The Basics Behind the Covered Calls

Posted on April 18th, 2011 admin No Comments

Despite the popular notion that is constantly being perpetuated by the mainstream media not all options trading strategies place an undue amount of risk on an investor’s portfolio. It certainly is true that many speculative techniques, such as selling naked calls and puts, increase your overall risk, there are numerous option trades that are not only safe, but are also moderately conservative. Perhaps the most widely used option strategy available to the average investor is selling covered calls.

The buy write strategy, as selling covered calls is also known as, is a relatively straight forward and simple technique to execute. As the seller the only thing you really must have is at least 1000 shares for every call option you want to sell. This is important since each option contract controls 1000 shares of the underlying asset. Additionally, selling a covered call gives the purchaser the right to buy a certain number of shares of stock at a certain price as long as the buyer actually exercises his or her right to do so.

As compensation for selling these options the seller receives payment, called a premium, from the buyer. This income stays with the seller regardless of the ultimate direction the underlying stock takes. It should be noted that the buyer has the right to buy the stock yet is under no obligation to do so. In fact, approximately 75% of all option contracts that are held until maturity expire with no value. Savvy investors know this and are constantly looking for ways to use covered calls to turbo charge their investment returns even in neutral or slightly declining markets.

Perhaps the most important part to this entire investing technique is that the seller actually owns an appropriate amount of stock to cover them in the event that the price of the underlying stock closes above the option’s strike price. If the investor did not own the underlying stock, and the options were executed, he or she would have to actually go out into the open market and buy a sufficient number of shares at the current market price to cover their obligation.

As there is no cap on how high the price of a stock can rise the investor would be exposed to an almost unlimited potential liability. It is, therefore, highly recommended that intelligent investors stick with covered call strategies as their option trading technique of choice.

Options Trading: Writing Covered Calls

Posted on April 13th, 2011 admin No Comments

One of the reasons I like investing in dividend stocks is that I feel that they are inherently less risky than non-dividend paying stocks. Each time a dividend is received, a small gain on your invested capital is ‘locked in’. However, in volatile markets, price fluctuations can be significantly greater (in percentage terms) than any dividends received. To help combat drastic swings in valuation, and to augment the income received from dividends, I’ve adopted a strategy of writing covered calls on suitable long positions.

Writing Covered Calls:
Writing covered call options can be thought of as getting paid for writing a limit sell order. As with a limit-sell order, a sell price is specified when the options order is entered which limits the maximum achievable capital gain when the contract is in force. If this sell price is not met when the option expires, you keep the options premium received (free money!) and the stock. The difficulty in implementing a covered call writing strategy is determining a personally acceptable maximum potential rate of return over the duration of the contract in relation to the options premium received.

Prerequisites:
As each call option represents 1000 shares of the underlying security, a covered call writing strategy can only be adopted on long positions involving at least 1000 shares. In addition, your brokerage account must also be approved for options trading.

Determining an Appropriate Options Series:
Determining what options series to open is highly subjective and is based on a number of factors unique to each investor such as the commission required to write options, the desired annualized yield from options premiums, and the minimum annualized capital appreciation. To determine the options series that I write for each of my positions, I use the following guidelines:

1.) Expiry Month
The expiry month of the options series determines how long the options contract will be in force. As an options’ time value decreases as it approaches expiry, writing contracts with an expiry far in the future will increase the options premium received for each contract. However, as the time value of options decays more rapidly the closer you are to expiry, the annualized options yield (premiums received per year) can be greater by writing options with expiries in near months (up to three months out).

My rule of thumb for most stocks is that using an expiry date three months into the future tends to provide a balance in terms of capital appreciation potential, options premium received, and trading commissions.

2.) Strike Price
The strike price of the option series sets the maximum price that you can ‘sell’ the stock for as long as the options contract is in force. In choosing a strike price, I look at the worst-case total return (capital gains over the life of the contract plus options premium received less commission) of the stock over the two to three month period to expiry.

In general, I tend to write out-of-the-money options with strike prices that allow a total return (not including dividends) of between 5-6% over the length of the options contract.

3.) Options Premium
As compensation for limiting the potential for capital gains over the length of the options contract, I want to receive at least a 5% annualized options yield (net of commission) on each position I write covered calls on. Ideally this yield would be higher, but with small positions (writing 1-2 calls at a time) commissions significantly reduce the options yield.

After examining a stock’s call option chain, if I cannot identify an expiry month and strike price that will provide an the annualized options yield greater than 5%, and a worst case total return (less dividends) of greater than 7%, I will not write the contract. Instead, I will wait until a more volatile market (options pricing increases with market volatility) and then enter into the position. Otherwise I do not feel adequately compensated over the duration of the options contract for the potential of lower capital gains.

Performance of Options Strategies:
Writing covered calls on open long positions will generally under perform the market in strong uptrends, but outperform the market in downtrends, flat markets, and provide equivalent returns during modest uptrends. By underperforming during strong uptrends and outperforming in downtrends or flat markets, the overall year-to-year highs and lows in the portfolio will be closer together resulting in lower portfolio volatility.

Over a number of market cycles, the total long-term return of covered call writing should at least equal that of straight buy-and-hold investing. However, the income generated by a portfolio active in writing covered call will be significantly greater than that of the buy-and-hold investor. This can allow for more frequent reinvestment of dividends and options premiums which can help to increase the overall compound growth of a portfolio.

Understanding the Basics of Covered Calls

Posted on April 4th, 2011 admin No Comments

Despite what the mainstream media would have you believe not every option trading technique is risky. Did you know that writing covered calls is often considered to be one of the safest, most conservative investment strategies available to the average investor? If you needed any further evidence of just how conservative this strategy is it should be noted that you can even sell covered calls within your individual retirement accounts. Perhaps the main reason why people have the erroneous belief that options are risky is simply because they do not understand the basic terminology involved.

When an investor decides that they want to start selling covered call there are just a few things they need to get started. The first thing they need to do is get permission to trade options from their Option broker. Most online platforms allow options trading by default so this typically involves reading a short pamphlet and then signing a form stating that you know what you are doing. After that, all you need is to own at least one hundred shares of the underlying stock for every call option that you want to sell.

Selling a call option essentially means that you are agreeing to sell a specific number of your shares of stock to another investor at a predetermined price. If the buyer exercises their rights to buy your stock you are then obligated to sell it to them at the strike price regardless of what the current market value of the stock is. This is perhaps the main reason you will always want to be in a covered position. In this instance, being covered simply means that you have a sufficient quantity of stock to sell the buyer without having to go into the stock market and buy it.

Of course, the seller would never agree to sell the rights to their stock if there was not something in it for them as well. Anytime an investor buys an option that must pay the seller a premium. This premium is based upon numerous factors such as how much time is left until the expiration date and how close the current market price of the underlying stock is to the strike price of the option. The premium income that the seller receives is what makes this technique so profitable.

Savvy investors know that most options that are held until the expiration date will expire with no value. As such, selling covered calls against stock positions that you already own is a very lucrative investment strategy when executed correctly.

US Income Strategy Recommendation: Lowe’s Companies Inc (LOW)

Posted on February 24th, 2010 admin No Comments

This is an Income Strategy Recommendation for investors looking to invest in the US market via US options. This recommendation is similar to the last two month as the trade last month expire safe/profitable and has returned $3410 USD and still believe LOW is a good investment. The recommendation is buy LOW shares at a discount to market. The recommended trade is to sell put options on LOW with the intent to purchase the shares. This recommendation is designed for investor looking to generate monthly income with capital protection. Instead of buying LOW shares today at market at $23.05 we can place this trade which gives an equivalent entry price at $22.52 a discount of 2.3% and a price I am happy to buy the shares at.

Trade

  • Sell 22 contracts LOW March $23.00 Puts @ 58 cents
  • Buy 22 contracts LOW March $21.00 Puts @ 10 cents

Net Credit 48 cents

Shares per contract = 100

Trade Summary
Maximum Profit $1,056 USD
Maximum Loss $3,344 USD
Breakeven $22.52
Return on Share Value 2.09%
Annualised Return on Share Value 25.04%
Return on Risk (ROR) 31.58%

If exercised we will purchase 2,200 shares at $23.00 which is a trade value of $50,600. When entering this trade you need to be aware and able to purchase the shares if exercised.

Brief Overview

Lowe’s Companies, Inc., together with its subsidiaries, operates as a home improvement retailer in the United States and Canada . The company provides a range of products and services for home decoration, maintenance, repair, remodelling, and property maintenance. It offers home improvement products in various categories, such as appliances, lumber, paint, flooring, building materials, millwork, lawn and landscape products, fashion plumbing, hardware, lighting, tools, seasonal living, rough plumbing, outdoor power equipment, cabinets and countertops, nursery, rough electrical, home environment, home organization, and windows and walls.

Reason for Trade

  • Technical Analysis – LOW is a buy at these levels with strong support at $22.00 and $23.00 and our breakeven is below this level.
  • Return on Risk above 30%
  • Capital Protection at 93.25%

US Option Income Strategy – Register your interest here…

We are now providing full service US option recommendation for the US options market. To register your interest in receiving US option recommendations or opening an account please contact me for more information.

Chart

If you would like to place the LOW recommendation, please email me your account number and quantity of contracts.


To receive US Option Recommendations or to learn more about trading options register for our US Option Trading please contact us on 1300 368 316 or info@totaloptions.com.au

Introduction to Option Trading: Combination Trades

Posted on February 22nd, 2010 admin No Comments

Introduction to Option Trading

These basic option positions when combined create option combination orders. These can be created via buying and selling options either put options or call options. Each of the following seminars and e-books will cover one combination strategy in more detail.

Summary

When buying options look to take advantage of their leveraged nature to allow large return with small capital outlay. When selling options look to sell when volatility is high and expected to decrease to help use time decay in your favour.

The information in this e-book is designed so the following Total Option Education Webinars and eBooks will build on this knowledge. The strategies in this book are used by traders everyday however they are normally used together to try and mitigate risks like time decay and volatility.


To receive ASX Option Recommendations or to learn more about trading options please request the complete Introduction to Options Trading eBook by contacting us on 07 5504 2244 or info@totaloptions.com.au

Selection Criteria – Selling Options

Posted on February 22nd, 2010 admin No Comments

When selling options, there are a number of variables to take into consideration. When you enter a sold call option your outlook needs to be that the share price will stay still or fall. Conversely, when you enter a sold put option your outlook needs to be that the share price will stay still or increase. Your objective is to sell time and you profit from your positions time decay. Also you can sell options when the volatility is high and expected to decrease throughout the trade. Your risk profile will determine whether you sell out-of-the-money calls for lower returns and lower risk at-the-money calls to receive more premiums with higher risk of exercise. Before placing any trade you must make sure there is enough open interest and volume through the options so liquidity is not an issue.


To receive ASX Option Recommendations or to learn more about trading options please request the complete Introduction to Options Trading eBook by contacting us on 07 5504 2244 or info@totaloptions.com.au

Selection Criteria – Buying Options

Posted on February 22nd, 2010 admin No Comments

When buying call options and put options it is critical to have good timing. When buying call options you don’t only need the stock to increase in value you need it to do so before the time decay in the option starts to affect the option value. Selecting the entry point (timing) of the trade can be assisted through technical and fundamental analysis. You can use technical analysis to identify break-out patterns to trade through buying calls or puts. It is important to make sure you buy enough time for expected movements. Also to make sure you buy your option at a reasonable price, you must analyse the volatility and make sure you are buying when volatility is low and expected to increase. Always make sure the option has enough open interest so liquidity is not an issue. If you stick to the blue chips this should not be an issue. Buying out-of-the-money calls is higher risk but potentially has large percentage returns. However, buying at-the-money calls has a higher delta but costs more so percentage returns are smaller.


To receive ASX Option Recommendations or to learn more about trading options please request the complete Introduction to Options Trading eBook by contacting us on 07 5504 2244 or info@totaloptions.com.au

Sold Put Option

Posted on February 22nd, 2010 admin No Comments

Writing a put represents a short put option, which is a slightly bullish or neutral position. This strategy entails writing (selling) the put option with an obligation to buy a fixed number or amount of the underlying asset from the holder at a fixed price on or before a specific period of time. The trader or investor who executes this strategy is called the writer. The risk inherent of naked put writing can be extremely high and always carries margin requirements.

The reward in this strategy is limited to the option premium received for selling the put option. The risk is unlimited. Writing puts is used if you are bullish on the underlying asset, and is used basically to collect the premium when a trader or investor feels strongly that the put option contract will expire worthless, or will be worth less than the premium received.

Selling put options can be an alternative to buying shares. For example rather than buy 1000 BHP at the current share price $30.00, you can sell at-the-money puts expiring in a month and receive $1.50 ($1500). This means your break even price on the shares is $28.50. You have basically sold insurance so if the share increases you get to keep the $1500 and sell another put option. If the share decreases you have bought the share at $28.50 instead of $30.00 anyway. There are many more variables to take into account regarding this strategy which will be discussed later in the course under income strategy. Please contact me in the meantime if you wish to discuss trading this strategy.

Summary:

Market Outlook Neutral/Bullish
Risk Limited to strike price less premium
Potential Reward Premium Received
Premium Received at purchase, margin required
Time Decay (Theta) Positive
Volatility (Vega) Negative


To receive The ASX Options Recommendation or to learn more about trading options please request the complete Introduction to Options Trading eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Sold Call Option

Posted on February 19th, 2010 admin 1 Comment

Writing a call represents a short call, which is a slightly bearish or neutral position. This strategy entails writing (selling) the call option with an obligation to sell a fixed number or amount of the underlying asset to the holder at a fixed price on or before a specific period of time. The trader or investor who executes this strategy is called the writer. The risk inherent of naked call option writing can be extremely high and always carries margin requirements.

The reward in this strategy is limited to the premium received for selling the call option. The risk is unlimited. Writing calls is used if you are bearish on the underlying asset, and is used basically to collect the option premium when a trader or investor feels that the call option contract will expire worthless, or will be worth less than the premium received.

Selling calls has a very useful function when combined with a share portfolio. The strategy is called covered calls. Rather than selling your shares you can sell at-the-money calls and receive a premium. You can use your shares to produce a monthly income and if the share price is above where you sold the call you sell the shares anyway and receive the premium as well. This is a simplified version but in a sideways to up trending market is very profitable. This strategy will be discussed later in the course under a number of strategies including covered calls, collars and income strategy. Please contact me in the meantime if you wish to discuss trading this strategy.

Summary:

Market Outlook Neutral/Bearish
Risk Unlimited
Potential Reward Premium Received
Premium Received at purchase, margin required
Time Decay (Theta) Positive
Volatility (Vega) Negative

To receive ASX Option Recommendations or to learn more about trading options please request the complete Introduction to Options Trading eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bought Put Option Example:

Posted on February 19th, 2010 admin No Comments

Buy 1 contract CBA May 2500 Put option @ 180 cents

This option gives you the right to sell 1000 CBA shares for $25.00 each, on or before the expiry date in May. If CBA decreases strongly below $25.00 by expiry of the option, you have locked in a higher selling price for the shares.

As the buyer of the option, you have a choice as to whether you want to exercise and sell the 1000 CBA shares or if you just want to sell the option.

For example, if you are right in your assumption, and CBA falls to below $25.00 over this time, you have locked in a higher selling price for the 1000 CBA shares at $25.00. You could elect to exercise your option and sell the shares, receiving the full face value of $25.00 per share plus other fees and transaction costs that might be applicable. Also, the option premium you paid at the start for this option would be deducted from the $25.00 selling price, so the break-even on this trade will be decreased by this amount.

Alternatively, if you decide that you don’t want to sell the shares, perhaps you were interested only in participating in the decrease in CBA’s share price; you could sell the option and profit from the increase in premium.

Worst case scenario, should CBA increase above $25.00 over this time, your option would lose value. If CBA is above $25.00 at expiry, the option would expire worthless. Should you now want to sell the shares, you could sell them at a higher price in the market. Even though the initial premium paid might be lost, the increased sale price of the shares will at least partially offset this.

Trade Summary

 

Exposure 1000 shares

Initial Investment = $1,800

Max Loss = $1,800

Breakeven = $23.20

Max Profit = $23,200

 


To receive ASX Option Recommendations or to learn more about trading options please request the complete Introduction to Options Trading eBook by contacting us on 07 5504 2244 or info@totaloptions.com.au