Understanding Covered Calls

Posted on August 15th, 2011 admin No Comments

It is easy to become a bit overwhelmed by the information and language when you first begin learning about options trading, and covered calls in particular. But covered calls are not much different than other investment strategies. The key is to find good sources of information and to learn as much as you can before investing. The covered call strategy can be a good money making source, but it is not a “get rich quick” scheme. If you are looking to become rich quickly, then you should look for some other strategy. On the other hand, if you are interested in a consistent way to earn monthly income, then covered calls are a good choice.

A few typical questions among new covered call investors:

Covered calls are what, exactly?

Also commonly called a “Buy Write” by some investors, a covered call is simply when an investor thinks that a stock has a good long term outlook but expects that the short term will stay relatively stable and trade within a few dollars of it’s current price. In this situation, the investor will then sell call options on the stock while simultaneously holding a long position on the stock. This is in the hopes of generating some income on the premium.

What is does “long” and “short” mean where stocks are concerned?

Being “long” a security (stock) means that you own it. This is the normal case. You bought it and if it goes up in value you will make money.

Being “short” means that you have sold a security (stock) that you do not own. At some point in the future you will have to buy it back to “cover” your short position.

How do I make money with covered calls?

You sell call options to buyers that allow them to purchase at a predetermined price, and they pay you a “premium” that is yours to keep whether the option is exercised or not. This guarantees you premiums regardless of the outcome, and creates income that you can count on.

How do I know when to sell these?

Generally speaking, you are trading future upside of a given stock for the right to make money short term instead. Given this, you would sell call options on stocks that you expect to remain fairly flat in the near term. If stock A is bought at $50 per share, and you expect it to stay at or near that mark for a period of time, then selling options is a good idea. This is the basic idea, although a trusted source of information can give you much deeper investment advice to narrow the choices further. Obviously you would not want to do this on a stock you expect to jump up in the near future, as you lose too much upside.

Source: Loraine Beecham

 

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Covered Call vs. Buy and Hold

Posted on August 8th, 2011 admin No Comments

Warren Buffett, the world’s richest investor, changed the paradigms of investing when he said he was a “decade’s trader”. He didn’t like flipping stocks since there were transaction costs involved. His mantra was simple: invest for cash flow. Covered calls are the latest innovation that will enable you to do so with ease. Read on to find out how.

Why Invest For Cash Flow

The entire gamut of financial investing activities revolves around two simple rules:

1. A dollar today is worth more than a dollar tomorrow – Covered calls give you the premiums right away.

2. A safe dollar is worth more than a risky dollar – Covered calls are safe in most cases as we will see in scenario analysis below.

Covered Calls vs Buy and Hold

In the traditional buy and hold strategy, you only receive cash flow in the form of dividends. These dividends are paid once a year on the face value of the stock. The problem is that dividends pay a negligible amount and are paid quarterly or yearly. If you were to recover the cost of your stock purchase, it could take you 20+ years to do so.

On the other hand, when you sell a covered call, you receive a payment for every call option you write. Contracts can be written monthly or quarterly. So, if you add this to your dividend payments, the amounts become formidable. You could end up recovering your cash in five years or less, if all goes well!

Understanding The Probabilities

In finance we typically work out a series of scenarios and assign probabilities to them before we decide to invest. Let’s look at the payoffs of covered call investing in different scenarios:

Scenario 1

Rising Prices: This is the most unlikely scenario now. The Dow Jones Industrial Average was less than 9,000 points in 2010 and is over 12,000 now. This dramatic surge is unlikely to continue in the coming months. Since the equities market in the BRIC (Brazil, Russia, India, China) countries as well as the prices of commodities like gold and oil are going through the roof, experts expect money to flow out of US equities in the long run. Also, prices must rise substantially. They have to go over the price of the call premium for the buyer to exercise it.

Covered Call Payoff: When prices go up, a covered call investor makes money.

Scenario 2

Stable Prices: This scenario is moderately likely, given the present circumstances. There is a status quo prevailing in the market as investors are uncertain about what the future holds. You can see this is the straight line in the Dow Jones Industrial Average graph of the past one month. It has been range bound fluctuating between 12,050 and 12,250 points. Until there are clear clues about what the future holds, it is likely to remain so.

Covered Call Payoff: You keep the time premium, as the option (being out of the money) will not be exercised.

Scenario 3

Falling Prices: This is most likely, given the recent crisis in Egypt and the Middle East. Oil prices are soaring leaving less disposable income in the hands of the consumer. The Fed is printing $2 billion daily to make coupon payments on outstanding debt devaluing the dollar. The fundamentals are weak and collapse is inevitable. But this will take time and, in the meanwhile, you can enjoy your income stream.

Covered Call Payoff: While the market bleeds, a covered call investor has some downside protection from the option he sold. It may not protect against a dramatic drop, but it will protect against the first part of any drop.

 

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Covered Call Option Strategy

Posted on August 3rd, 2011 admin No Comments

Options have become a popular investment in recent years. You can make more money than stock if you done it the right way. There are many options strategy you can use. The basic one is call option and put option. Option is a right to sell or buy an asset at a specific price or what is called strike price.

Besides basic strategy there are also many advanced strategy which is created using several basic options. One of that advance strategy is covered call. This is strategy when you think the stock is bullish but will not move a lot in short term. In that short term you want to make money by selling call option, because when you sell or write option you will receive premiums.

This strategy has limited profit and it will happen when the stock price is at or above call option strike price. Covered call can also bring a lot of loss if the stock drops to 0 but your loss will be offset by the premium you receive when writing call option.

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The Covered Call Option Strategy

Posted on August 1st, 2011 admin No Comments

Covered call is an option strategy which is created when an investor hold a long position in a stock and write call options on that same stock. This strategy is used when you think that the stock is bullish but it will have limited price change during the option life. When writing call options you will get premium which will increase your return when the stock does not move a lot or when in consolidation. This strategy will give you the benefits of underlying stock such as dividend and voting rights.

Covered call has limited profit and very high loss when the stock drops to 0. Maximum profit will happen when the price of stock is at or above the call option strike price. Your stock loss will be offset by the premium you get when writing call option.

Here’s an example for you to understand it more. You bought stock ABC at $50 and write a call option at strike price $60 for $5 premium.

There are 4 final results:

Stock ABC price is below initial purchase price at $40. Your loss from the stock will be $10 and it will be offset by the $5 premium. So you total loss is $5.

Stock ABC price is above initial purchase price but below strike price at $55. Total profit from stock and $5 premium will be $10.

Stock ABC price is at strike price at $60. Total profit from stock and $5 premium will be $15.

Stock ABC price is above strike price at $70. Your total profit will be the same like when it is at strike price which is $15.

 

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Covered Calls Investment

Posted on July 27th, 2011 admin No Comments

Sometimes covered calls are also known as Buy Write. They are a common technique used to trade in shares, foreign exchange, and other securities. In lay terms a cover call is a strategy where an investor holds a long position then waits for an opportunity for him to write call option. If this opportunity avails itself he has a chance of increasing his income.

If you use this tool well, covered call trading strategy has the ability to generate some good profits in the long run of any security. This tool is generally considered safe if not conservative though, it has a number of flaws which we are going to have a look at. We are also going to see all the ups and downs that surround this tool.

Before we continue it will be important to have a few definitions:

A long call option – In this case you buy a contract that allows you to purchase an underlying or a security on or before a specified future date. The price of the security is usually predetermined. This is the strike price. You will have to pay some amount for you to be able to hold this right.

Sell call option – This is an instance where you are the issuer of the long the call option. In this case the person whom you are offering the right pays you. Short the put option. Here you give an investor or trader a right to sell at a future date in which he does not have to sell to you. Basically these are the underlying points in any buy write strategy.

Source: Joe Suttles

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Writing Covered Calls

Posted on July 25th, 2011 admin No Comments

In many ways the covered call strategy can be considered less risky than simply owning shares of stock. Of course, this truly depends on how aggressive, or conservative, this technique is implemented.

What are Call Options?

A call option is simply a contract between two investors in which the seller of the option agrees to sell a portion of their stock to the buyer if the buyer elects to do so on, or before, the expiration date. In exchange for essentially giving up the rights to their stock, should it rise above the strike price, the seller receives a cash premium from the buyer. This premium income stays with the seller regardless of what happens to the price of the underlying stock.

Potential Outcomes When You Sell a Call Option

Most covered call writers will tell you that writing covered calls typically is most effective in relatively flat, or slightly rising, stock markets. In these types of market conditions, the seller generally receives more income from collected premiums than the potential gains that are forfeited by being called out of the position.

If the price of the underlying stock remains at, or below, the strike price at expiration, the investor (that is, the seller) banks the additional income from selling the option and gets to hold onto the stock. They are then free to sell another call against the same shares next month to generate even more income. If the price of the stock has declined significantly, the covered call writer’s loss is reduced by the amount of premium income they collected; effectively reducing their cost basis.

If the price of the underlying stock rises above the strike price at expiration, the seller must sell the agreed upon number of shares to the buyer at the strike price; even if the current market price is significantly higher. The seller does get to keep the premium income and the cash that is generated from the sale of the stock.

Mastering the Covered Call Strategy

While it is certainly true that selling covered calls is a great way to generate additional income from an existing stock portfolio, there are many variables that need to be carefully considered.

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Why A Covered Call Strategy Is Considered Safe Investing

Posted on July 20th, 2011 admin No Comments

Covered Call strategy, which is a low risk way to earn income from a stock portfolio. The income is earned by writing options. Options are a leveraged investment where you can control a large number of shares with a minimal investment. Leverage allows the investor to obtain a higher rate of return on their investment. However, leverage also has some inherent risks.

As an investor you can buy options or you can write them. There are two types of options: calls and puts. A call option gives the buyer a right to buy one hundred shares of stock at a certain price for a limited period of time. A put option gives the buyer a right to sell one hundred shares of stock at a certain price for a limited period of time.

The price that you can either buy or sell the shares is called the strike price. The cost of the option is called the premium. Call option prices go up and down in tandem with the underlying shares of stock. Put option prices go up and down in the opposite direction of the underlying shares of stock.

If the owner of the option decides to exercise their option, the option writer will have to sell their shares of stock to holder of the option. This will incur a minimal loss. It is easy to see how this is a conservative investment approach for the option writer. There are ways of offsetting the deal to protect the option writer.

With leverage the investor has the potential to earn a higher rate of return on their investment. This is because they are only putting up a fraction of the full cost of the shares. The risk of using leverage is that the investor can be wiped out faster if there is an unexpected drop in share prices.

With leverage there is the possibility to make a greater rate of return on your investment. On the other side of the coin, a small price fluctuation can render your options worthless. For the writer of the calls options, the chances are that the option will never be exercised. If the price of the underlying stock does increase, the write of the option can always purchase an option to offset the transaction. This is what makes this such a safe investment.

When an investor has a large stock portfolio they can constantly be writing options to have a continuous flow of income. Since they already own the shares this is a relatively risk free income generating technique. Not all option techniques are as safe as this one is. There are very complex transactions that are put together by professional investors and hedge funds. The ordinary investor does have to concern themselves with these to earn a nice flow of income.

Using the covered call strategy is an easy and safe way to earn some income from a stock portfolio. Not all common stocks are listed on the option markets. For this reason, if you are interested in using this technique make sure the equities you buy are listed on the options exchange. A stock broker who specialises in options may be able to assist you.

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The Covered Call Stock Option Strategy

Posted on July 18th, 2011 admin No Comments

A popular stock option strategy used by investors is the covered call. The covered call is one in which you would write a call option contract for a number of shares of stock you actually own. If you own the stock before writing the call option it is called an overwrite. If you buy the stock as you create the call contract, it is called a buy-write.

The stock you own is covering the call option contract which is where the name is derived from. This stock option strategy is generally used when the market is going sideways or you form an opinion that a bull market is developing.

With the covered option, the price for the underlying asset has been determined already unlike in a naked option where you don’t own the stock. When the option is uncovered, you will have to go to the market to buy the stock if and when it becomes necessary to cover the option. It is possible to cover your option at any time before the expiration date of the option contract.

The covered call stock option strategy is less risky than the uncovered option simply because you already know the price of the underlying asset. The covered call is used to generate income from the underlying asset or stock.

You get to keep the premium on the covered call and if the contract expires then you also profit from any gains in the stock value. If the option is exercised you will earn the premium in addition to the difference between the purchased stock price and the strike price. This stock option strategy can also protect you from underlying stock that that may experience a price decline.

The breakeven point for the covered call stock option strategy is equal to the stock purchase price less the premium received.

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Covered Call Opportunities and Risks

Posted on July 13th, 2011 admin No Comments

The most popular options-based strategy is called covered calls and consists of owning stock while at the same time selling call options against that stock. Although it is a very good way to generate recurring monthly income from a portfolio of ETFs and stocks, it is not without risks.

The first risk is an unexpected tax event. Because American style options can be exercised at any time, the seller of the option (i.e. the covered call writer) has a risk that the buyer will exercise the option prior to expiration. Normally it doesn’t make any sense for the buyer to exercise if there is still time premium remaining in the option, because the buyer gives up the time premium when he exercises. So if he wants to get rid of his option that still has time premium in it then he is better off just selling the option instead of exercising it.

However, there are some irrational people in the market and occasionally the covered call writer will receive an assignment that doesn’t make financial sense. The risk is that the call writer ends up having stock he owns called away which creates a tax event from the sale if the stock was held for more than twelve months. Sometimes option holders will do this the day before an ex-dividend date if there is only a tiny bit of time premium remaining in their option so that they can capture the dividend.

Next risk is the reduced upside potential above the strike price. The covered call writer can set the strike price to any value he likes, but one thing certain — whatever value he sets it to is the most he will receive for his stock between now and expiration. If there is a happy surprise of any kind (M&A takeover, earnings beat, increased guidance, competitor fails, etc) and the stock shoots up over the strike price then the covered call writer will not earn as much as he could have made if he hadn’t written the call.

Covered calls won’t prevent losses. Some investors feel a sense of comfort because of the option premium they received when they shorted the call. However, it won’t be enough to protect against losses if the stock drops below the breakeven point of the covered call trade (stock price paid less the option premium received). While there is some downside protection in a covered call position, it is not infinite. Stocks can drop significantly in a short period of time. In this case the covered call writer will lose less than the buy and hold investor, but it may still be a loss nonetheless.

And then we come to yield chasing. It is very enticing to use a covered call screener to identify the high yield covered calls and then start selling them. But the screener is just the 1st step in any covered call program. After you get a list of candidate trades from the covered call screener you then must do additional research to understand why those premiums are so high. You can make a great return with covered calls but like any other strategy you must be prudent and proceed with carefully researched caution.

Source: Keith Pelletier

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Writing Covered Calls for Additional Income

Posted on June 13th, 2011 admin No Comments

Investors who wish to generate additional income while waiting for long term price appreciation of a particular stock in their portfolio might want to consider selling covered calls. The covered call is a strategy in which an investor/trader writes or “sells” a call option contract while simultaneously owning an equal number of shares of the underlying stock. This strategy is designed to generate additional income and is most successful when one has a neutral to slightly bullish view on the underlying stock. First, let’s examine the basics.

A call option is a contract that gives the buyer the legal right to buy shares of the underlying stock at the strike price, before the expiration date. For this right, the buyer pays the seller a premium, which the seller collects and keeps. The buyer is never obligated to purchase the shares and can allow the option to reach the expiration date, at which point it expires and becomes worthless.

Buying Calls

For example, if Jack purchases the 12.50 Jan 2011 call option on the underlying company Activision Blizzard, Inc. (ATVI) for $0.33, he pays $33 (0.33X100) for the right to buy 100 shares of ATVI at $12.50 until expiration of date of Jan 21st 2011 (options contracts expire the 3rd Friday of the expiration month). Jack thinks that the upcoming release of World Of Warcraft: Cataclysm will generate billions in sales and additional revenue for ATVI and send the stock rocketing upward.

If the stock doesn’t close above $12.50 on Jan 21st Jack’s call option expires worthless and he loses his $33 dollar investment. In fact, Jack would need to stock to close above $12.83, (his breakeven point 12.50 +0.33) since he had to pay for the call option. However, if Jack is correct and sales of WoW send the share price of ATVI to $20.00 his call will be “in the money” and he can exercise his right to purchase the shares for $12.50 and will have gained a substantial profit.

Selling “Covered” Calls

Jill is a long term ATVI stock holder and while she believes in the long term growth of the company, she knows the stock has been stuck in a $10 to $12 trading range for the past few years. She purchased the stock at $9.00 and still believes it has room for further appreciation, but could take years. Since the stock is trading near the top of the historical trading range and likely to head back toward $10 she sells the 12.50 Jan 2011 covered call for 0.33 and receives a $33 premium for selling the contract.

At expiration if the stock is under $12.50 she keeps the $33 premium and keeps her 100 shares of ATVI, providing her some additional income. Jill repeats this strategy every few months to keep generating income. However, if the price rises over $12.50 before the Jan expiration the option has gone “in the money” and she can be randomly exercised and forced to sell her 100 shares at $12.50, regardless of how high the price rises. Since Jill bought the stock at $9, she locks in a gain of $383 ((1250+33) – 900) but misses out on any further price appreciation because she no longer holds her 100 shares.

In conclusion, selling covered calls can be used to generate additional income for investors who already hold shares in a specific company. Not all stocks allow options trading and this example doesn’t include any fees that must be paid to the broker for buying or selling options contracts. In general, one would want to sell a covered call when they have a neutral or only slightly bullish view on a particular stock, or when a stock is stuck in a clearly defined trading range.

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