Chances are you know that elemental sodium and elemental chlorine are both absolutely deadly.
Put some sodium in water and it immediately blazes into white-hot flames. Inhale a few breaths of 100% pure chlorine (the stuff you pour into swimming pools is only 2% chlorine), and you will have no further concern about the national debt, or anything else.
Yet if you mix them together you’ve created the perfect compliment for a bag of popcorn: NaCl, common table salt.
As it happens, there is an investment analogy. One of the most dangerous investment strategies available is selling “naked” call options. Doing so offers a relatively small amount of profit potential in return for unlimited risk – a formula for blowing up an investment account.
But, if you sell call options “clothed” in the underlying stock, you have perhaps the safest, most conservative investments available. It is a technique that many investors – even sophisticated ones – either overlook or do not fully appreciate. If you own stocks and are not employing this simple tactic, you are leaving a great deal of money on the table.
If a stock broker were to utter the phrase “risk-free” within earshot of a client, the firm’s entire Compliance Department would instantly dissolve into a dead faint.
But when you sell call options against stock your already own- thereby creating a covered call – the amount of money in your account cannot go down as a result of selling the call. The approach is unique in that it works every time. And when you finish reading this report, you may want to begin using it if you do own stocks you plan to keep for a while.
Because of the enormous risk involved in selling naked calls, brokerage firms require special forms to be signed by the customer who wishes to make such trades. However, selling covered calls is so safe that it is approved for retirement accounts (IRAs and Roth accounts).
There are two flavors of options: Call options and Put options. Calls give the buyer of the option the right, but not the obligation, to purchase 100 shares of the underlying stock at a predetermined price, known as the Strike Price.
When buying a Call, the buyer is hoping that the price of the underlying stock will move above the Strike Price prior to the expiration date of the option, thus providing him with a profit.
The reality is that most buyers of out-of-the-money options lose money buying them because of time decay. As time passes, the time value of an option inexorably declines and will reach a zero value at expiration if the underlying stock has not exceeded the Strike Price by expiration day. [This is the foundation of The Monthly Income Machine, a very conservative approach for generating substantial monthly income from the stock market without actually owning any stock. It’s conservative, but it’s not risk-free.]
Now let’s look into another technique for the income seeker who happens to own shares of stock in his portfolio.
How to Use the Covered Call Strategy
First check to see if options are available on the stock you own (happily, for most listed stocks there are associated options).
Decide at what price you would be willing to sell the stock if it reached that price in thirty days or so (in other words, you don’t expect it to get that high in a month, but if it did, you’d be willing to sell the stock at that price).
NOTE: remember that even if you did sell it at that price, you could always buy the stock back again later.
Sell 1 of next month’s XYZ Call options for every 100 shares of XYZ you have, using the Call option that has the Strike Price at which you would gladly sell the stock.
The amount you receive for the sale of the option is called the “premium” and that money is reflected immediately as an addition to your account value. You do not “buy” anything when you do this; you are selling a derivative financial instrument and collecting the money for it up front.
Sit back and wait until the expiration day of your Call option (each month’s options expire on the third Friday of the month.)
If the price of the stock on options expiration day is below the Strike Price you selected, you bank all the premium money you collected for the sale of the option because the option has now expired worthless and cannot be exercised by the buyer.
If the underlying stock price has exceeded the Strike Price, you can elect to take no action, and your stock will be “called away.” That means you will sell your stock to the owner of the call option at the Strike Price amount/share you decided earlier was a big enough one-month profit for you to be happy to sell the stock. You also keep all the premium money you received from the sale of the Call option.
If, as is usually the case, the stock finished below the Strike Price of the Call, you then do the same thing with next month’s options, again selecting a Strike Price at which you would be happy to sell the stock if it reached that price during the month. You do this, collecting another premium, every month!
In a bit, we will go through an actual Covered Call Trade to review the delightful arithmetic.
What Strike Price?
That is a personal decision based on how much additional stock profit you want during the month to entice you to be willing to sell the stock. You might decide to use 15%. That means if your XYZ stock is currently at $100, you might be willing to sell it within 30 days at $115. If so, you could sell next month’s $115 Strike Price Call for whatever the premium is on that Call at the moment in time when you place the covered call option trade.
Or, you might decide the stock needs to go up 20% before you would be willing to sell. In that case, you would sell a call with a $120 Strike Price, and so on.
Obviously, the higher the Strike Price of the Call (the further it is from the current price of the underlying stock), the less the premium you will collect because buyers correctly assume it will be less likely to reach that higher level.
You can even set your Strike Price so high – say 30-50% above the current price of the underlying stock – that there is virtually no chance of the price being reached and the stock being called away from you at that very high Strike Price. Setting an extraordinarily high Strike Price will, of course, reduce the amount of premium you can earn that month as noted above.
In any case, no matter what the Strike Price, and whether or not the underlying stock reaches it by expiration day, you keep the premium you received when you sold the Call.
Possible Outcomes of Selling Covered Calls
There are only three possible outcomes to selling a Covered Call:
1. Side Way
The price of the stock stays about where it is, or goes up or down somewhat, and does not exceed the Strike Price of the Call option on option expiration day.
Result: you keep the stock and the premium you earned by selling the Covered Call AND YOU CAN REPEAT THE PROCESS TO EARN ANOTHER PREMIUM NEXT MONTH.
2. Strong Down
The price of the stock goes down significantly during the month, so again it does not exceed the Strike Price of the Call option on option expiration day.
Result: again, you keep the stock and the premium you earned by selling the Covered Call AND YOU CAN REPEAT THE PROCESS TO EARN ANOTHER PREMIUM NEXT MONTH.
Note: the stock going down has nothing to do with the Covered Call trade, i.e. if the stock goes down, it goes down… your covered call has nothing to do with causing that decline in the price of the stock.
In fact, the premium you collected when you sold the Call helps to cushion the effect of the decline of the stock’s price.
3. Strong Up
The price of the stock goes up a lot and exceeds the Strike Price of the Call option on option expiration day.
Result: The buyer of the Call you sold has the right to buy the stock from you at the predetermined, higher, Strike Price. Thus, you do sell the stock at the Strike Price you predetermined was a satisfactory profit and, once again, you keep the premium you earned by selling the Covered Call, as well as the profit on the sale of the stock.
You can of course simply re-purchase the stock – perhaps at an even lower price – if you wish to own it once more after option expiration day, and then begin selling Covered Calls again.
Example of Covered Call Transaction
Assume you own 500 shares of ABC stock currently trading at $155.02, and you would gladly sell the stock if it jumped more than 15% to $180… in less than a month.
Since each Call option is for 100 shares of the underlying stock, and you own 500 shares of ABC, you would Sell 5 Calls, Strike Price $180. For this example, we’ll assume the premium on next month’s ABC 180 Calls is $2.44/call.
Premium Dollars Received: $2.44 premium x 100 shares/call x 5 Calls = $1,220.00 (less about $6.25 total commission)
That $1200+ extra return in one month required no investment purchase or margin because the stock you already own represents the entire necessary margin.
During the weeks, months or years you own a stock, the strategy discussed in this report will almost certainly produce more money in your account than the dividends the company pays you on the stock.
The Bottom Line on Covered Calls
You win, no matter what! If your stock doesn’t reach the Strike Price of your Covered Call, you bank the premium you collected.
If your stock goes down, that would have happened whether or not you did your Covered Call trade. The premium you received on the Covered Calls cushions the decline– in the earlier ABC example – by $2.44 per share.
If your stock goes above the Strike Price, you sell your stock, currently trading at $155.02, at the $180 price you predetermined would be a satisfactory $25/share profit for thirty days. In addition to the big one-month profit, you also have the $2.44/share premium you earned.
Finally, if you do sell the stock, you can always repurchase it, likely at about the same price you sold it for, or even lower if there is some profit taking after the big move that allowed you to realize the $180 selling price. I emphasize this because some pundits claim that having the price of your stock “capped” by the Strike Price is a disadvantage to selling Covered Calls.
I maintain this is simply not so. You predetermine the price at which you would be happy to bank some profit on your stock in such a short time. So if the stock reaches that Strike Price, you have the profit you wanted (in addition, of course, to the premium you earned). Furthermore, you are free to buy the stock again – and sell covered calls against it again – anytime you wish.
Speaking of “Anytime You Wish”
Keep in mind that while you realize the maximum premium acquisition by waiting till expiration day and having the stock finish trading that day below your Strike Price, you DO NOT NEED TO wait till expiration. You can buy back (offset) the Covered Calls you initially sold anytime prior to option expiration day if you wish.
An Interesting Letter to the Editor of Forbes Magazine
Finally, I have no idea who Howard W. Burdett of Mackinac Island, Michigan is. But he wrote a Letter to the Editor of Forbes Magazine (October 19, 2009 Special Issue) in which he summarized his view very well indeed:
“I view the writing of covered-call options as being the “house” in the great casino of the stock market. If someone wants to pay me at the rate of 20% for the right to buy stock at a fixed price sometime in the future, I’m willing to sell him that right. If he hits the jackpot, I cheer for him. In most cases the stock does not go up sharply and the option (that he bought) makes little or no profit (for him). In any case, I continue to make my 20% cash return from the premium I have received.”
Well said and Amen, Howard.
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