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Hi All, I am going to talk about what is covered call strategy and when to use the same. Covered Call is a strategy in which an investor sells a call option on a stock he owns. In this strategy, the investor generally sells an Out of the money call option (Strike price > Current market price). The call would not get exercised unless the stock price increases above the strike price. Till then the investor in the stock (call seller) can retain the premium with him. This becomes his income from the stock. This strategy is usually adopted by a stock owner who is Neutral to Moderately Bullish about the stock. Writing out-of-the-money covered calls is an excellent strategy to use if you are mildly bullish toward the underlying stock as it allows you to earn a premium which also acts as a cushion should the stock price go down. So if you are planning to hold on to the shares anyway and have a target selling price in mind that is not too far off, you should write a covered call. Happy Learning
Dr. Edward Olmstead, Professor, Northwestern University Chief Options Strategist, Dr. Olmstead’s Options Trading Strategies The option strategies discussed here extend the discussion on covered calls, initiated in our article on Covered Calls posted last week. They present ways to enhance or recapture a return on stock you already own (underlying position), even if that stock is showing a loss in your portfolio. The stock enhancement strategy can be used to greatly improve the return on a stock that you own. This is an options strategy that can be implemented at no additional cost beyond the original expense stock ownership. It also has no margin requirement and hence can be done in a retirement account. This strategy can be viewed as an extension of the covered call concept, although the motivation and time frame for the trade are unlike that of the typical covered call. The same strategy can be used to accelerate the recovery in value of a stock that has suffered a significant drawdown. In this case the strategy is known as the stock repair strategy. Again, it is a no cost trade. Stock Enhancement Strategy For this strategy to work, it is necessary for your stock to make some reasonable gain over the next 5-6 months. This strategy is intended to convert a reasonable profit in the stock into an excellent overall return at no cost beyond what you paid for the stock. For each 100 shares of stock, the basic plan is to sell one out-of-the-money call with a strike price at the level you expect the stock to reach in 5-6 months. This combination is just a covered call trade, except that it goes much further out in time than you would expect with a typical covered call. Next, you use the proceeds from the sale of the covered call to pay for a one contract bull call spread. The upper strike for the bull call spread will be the same as the covered call, while the lower strike for the spread will be nearer the current price of the stock. Let's look at an example to illustrate the stock enhancement strategy: Example: Many analysts are forecasting significant gains in the prices of copper and gold over the next 5-6 months. A good way to play this forecast is to buy Freeport McMoran (FCX), a strong company that specializes in both metals. To boost the return in this investment, the Stock Enhancement Strategy can be employed. Trade: Buy 100 shares of FCX at $35.50 per share. Buy 1 Nov. 37 call for $2.3 per share and sell 2 Nov. 40 calls for $1.20 per share. The option transactions actually produce a net credit of $.10 per share to help pay for your commissions. Position: This holding can be viewed as a covered call (long 100 shares FCX and short 1 Nov. 40 call) and a bull call spread (long 1 Nov. 37 call and short 1 Nov. 40 call). Payoff: If FCX is above $40 at the November options expiration, the stock will be called away at $40 for a $4.5 per share gain over its purchase price. The bull call spread will be worth $3 per share. The total gain of $7.5 per share represents an excellent return of 21.1% on a stock that only needed to move up by 12.6%. Comment: Remember that this is a no-cost trade. If FCX does not reach $40 by the November expiration, the Nov. 37 call will still provide a profit if the stock price exceeds $37. An additional bonus on this particular trade is that FCX pays a nice annual dividend of which about half can be captured over the next 5 months. Stock Repair Strategy Using the same approach as the stock enhancement strategy, it is possible to recover the full value of a stock whose price has suffered a large pullback. For the repair strategy to be effective, it is necessary for the stock to make some modest gain in the next 3-4 months. Let’s look at an example to illustrate the stock repair strategy: Example: Those who bought 100 shares of Facebook Inc. (FB) at $38 per share during its IPO in May are now looking at a deflated price of $31.70 in mid-June. With a modest increase in the price of FB over the next 3 months, the Stock Repair Strategy can more than make up for the lost value. Trade: For each 100 shares you own, buy 1 Sept 32 call for $3.2 per share and sell 2 Sept 36 calls for $1.6 per share. This is a no cost trade. Position: This holding can be viewed as a covered call (long 100 shares FB and short 1 Sept 36 call) and a bull call spread (long 1 Sept 32 call and short 1 Sept 36 call). Payoff: If FB is above $36 at the September options expiration, the stock will be called away at $36 for a $4.3 per share gain over its mid-June price of $31.70. The bull call spread will be worth $4 per share. The total gain of $8.3 per share represents an equivalent stock price of $40.00, which is $2.0 per share better than the original purchase price. Comment: Remember that this is a no-cost trade. If FB only reaches $35 by the September expiration, the Sept 36 calls will expire worthless and the Sept 32 call will still provide enough profit to effectively raise the stock value back to its original price of $38. Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education material and option trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com.
Dr. Edward Olmstead, Professor, Northwestern University Chief Options Strategist, Dr. Olmstead’s Options Trading Strategies One of the first strategies that someone new to options hears about is the covered call trade. Frequently, this strategy is touted as a safe and simple way to make money with options. Many brokerage firms allow covered calls as the only options trade that can be made in a retirement account because it is “conservative.” Unfortunately, this description of covered call trades as conservative is highly misleading. Ask those same brokers who only allow covered call trades in retirement accounts how they feel about selling naked puts. They will explain how that type of trade is much too risky to be allowed in a retirement account. Well, at least they got that part correct ---- selling naked puts does involve significant risk. The truth is that a covered call trade has exactly the same risk and reward characteristics as selling a naked put. More about this later. In its simplest form, the covered call trade requires that you own 100 shares of stock. Then you can sell one call option contract with a strike price that is above the current stock price. In this situation, the call that you sold is said to be “covered” by the stock that you own. If it happens that the option is exercised, your brokerage account possesses the stock that must be made available for sale at the strike price. The cash received from selling the call is yours to keep no matter what happens. Here is the idealized description of what happens when the call option expires. If the stock price is above the strike price of the call at expiration, your stock will be called away for a price that is presumably higher than your original purchase price ---- you have made a profit on the price increase in the stock and you also have the cash received from the selling the option. If the stock price is below the strike price of the option at expiration, then the option expires worthless and you keep your stock ---- you again have the cash received from selling the option, and you are free to repeat the process by selling another call in the next option cycle. As you can see in this idealized version, the covered call trade has the potential to generate regular profits by repeatedly selling call options against stock that you own. Unfortunately, the covered call trade is not nearly as straightforward as the idealized description would suggest. Stock prices undergo considerable fluctuation over time and, all too frequently, the stock price on the expiration date will be either well above or well below the strike price of the short call. Both scenarios present a difficult decision going forward. If the stock price is much higher than the strike price of the call at expiration, you may be reluctant to give up your stock at a price that is well below its current level, and thus forego any future gains in the stock price. The only alternative is to buy back the short call for a significant loss in order to continue holding the stock. If the stock then fails to perform as expected, it may be quite difficult to make up for the loss incurred from buying back the short call. If the stock price is much lower than the strike price of the call at expiration, you keep the stock, but you are faced with the challenging decision of which call strike to sell for the next option cycle. If you sell a high strike in order to give the stock price room to move up, the cash received from the sale may be miniscule. On the other hand, if you sell a strike nearer to the current stock price in order to receive more cash, you lose the opportunity for the stock to regain all of its lost value. Now let’s get back to comparing a covered call with selling a naked put. To see that these two trades have the exactly the same risk and reward characteristics, examine cases in which the stock price at expiration is either above or below the strike price of the option. To make things definite, consider a specific example. Covered call: With XYZ at $53, you buy 100 shares of stock and sell one 55 call option for $2.0 per share. This means that you have equivalently purchased 100 shares of XYZ for $51 per share. If the XYZ has fallen to $40 per share at options expiration, you will have lost $1100 on this trade. The maximum reward that you can receive on this trade is $400, which occurs when the stock price exceeds $55 at expiration. Naked put: With XYZ at $53, you sell one 55 put option for $4.0 per share, which pays you $400. If XYZ has fallen to $40 per share at options expiration, the option will be exercised and you will be required to buy the stock for $55 per share. Subtract the $400 you received and your loss on this trade will be $1100. The maximum reward occurs when the stock price exceeds $55 at expiration and you get to keep the $400 received from the sale of the put. If you are going to do covered call trades, then be aware that it is not a conservative trade and be prepared to make a challenging decision when the options expiration date arrives. Here are some suggestions for handling covered call trades: 1. Since almost all of your risk is in what you paid for the stock, focus your attention on the stock price and to a much lesser extent on the option price. Decide on an appropriate stop loss price for the stock, and if it falls to that level, protect the major portion of your investment by selling the stock and buying back the call. Do not hang onto to a falling stock in order to collect an extra $.50 per share from the short option. 2. When deciding upon the strike price of the call that you are going to sell, make sure it is a price at which you will feel comfortable in giving up your stock if necessary. If your goal is to keep your stock under all circumstances, then select a higher strike price. If you are willing to sell your stock closer to its current value, then pick a nearby strike price to bring in more cash. 3. Do not sell a call with an expiration date too far out in time. Those juicy premiums in the longer-term options are tempting, but you will generally do better by selling the front month call. In today’s volatile market, a stock can have big moves (up or down) in 4-8 weeks. By selling near term options, you will be better placed to make an adjustment when the expiration date arrives. 4. Do not be greedy. If the stock price is above the strike price at expiration, take your profit and move on to a new trade. Avoid buying back the option for a loss unless you have a very compelling reason to do so. If you buy back the option for a loss and then the stock price subsequently collapses, you will have compounded a loss on the option with a loss on the stock. ### Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education material and option trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com
Traders who implement an ITM covered call strategy writes (sells) a call option for leverage against potential losses on owned shares. They also gain a steady premium when the market rises. The strategy involves writing a call option ITM and buying the same number of regular shares of the underlying asset. A long call strategy guarantees traders a steady return in bull markets. Premiums received from writing the call cut losses, if the price of the underlying asset falls. Definition of ITM, ATM and OTM for Covered Calls There are three ways to define the relationship between an option's strike price and the market price of its underlying asset. Understanding the differences between the terms is important when considering the returns involved in implementing a covered call strategy. ITM - In The Money: The underlying asset's market price is more than option's strike price. Example: - Call Option XYZJan45 (strike price $45) - XYZ is trading at $50 ATM - At The Money: The underlying asset's market price equals the option's strike price. Example: - Call Option XYZJan45 (strike price $40) - XYZ is trading at $45 OTM - Out of The Money: The underlying asset's market price is less than option's strike price. Example: - Call Option XYZJan45 (strike price $40) - XYZ is trading at $55 How to Implement a Covered Call Strategy (ITM) XYZ is worth $50 (market price) 1) Trader buys 100 shares of XYZ preferred stock and pays $5000. 2) Trader writes (sells) a call option: XYZJan45($7) - 100 shares of XYZ stock - Strike Price $45 (ITM), expiring in 30 days - Premium Cost of $7 3) Trader receives $700 in premiums (100 x $7 (premium cost)). Total Investment cost: $4300 [$5000 (paid) -$700 (premiums collected)] Result one: XYZ hits $55 (ITM). The call buyer exercises his or her right to buy 100 shares at $45, paying $4500 for the seller's assets. After adding the $200 in premiums received, the trader's covered call strategy results in a $200 profit [$4500 (received) - $4300 (Paid)]. Result two: XYZ hits $45 (ATM). The call buyer lets the option expire and the writer keeps the premiums paid. The shares held by the writer loses $500 in paper value [$5000 (paid) -$4500 (worth on strike date)], but since the writer received $700 in premiums, he or she still makes a profit of $200. [$700 (premiums collected) -$500 (loss)] Result three: XYZ hits $40 (OTM). The call buyer lets the option expire and the writer keeps the premiums paid. The shares held by the writer loses $1000 in paper value [$5000 (paid) -$4000 (worth on strike date)], but since the writer received $700 in premiums, his or her loss reduces to $300. [$700 (premiums collected) -$500 (loss)] Advantage and Disadvantage of Implementing a Covered Call Strategy: Pluses: The upside to this type of strategy is that the investor will always make a profit when the price of the underlying asset rises. Another advantage in using a covered call strategy is that the investor can also profit from a drop in price of the underlying asset. Writing the call option leverages the investment against market downturns, and it gives the trader a cushion for reducing his or her losses. Minuses: The downside in using covered call strategy is that the method limits an investor's profits. If the underlying asset's market value takes off, the trader cannot take advantage of the gain because he or she must sell assets at a fixed price after assignment.