The first of a two part look at Covered Call Writing. In this first part, we start with the basics.
When you embark upon your first adventure into options trading, there are those who will tell you that "covered call writing" is the safest strategy. Even brokerage firms allow novice option traders to trade covered calls in their IRA accounts. Little do they know. Or, if they really do know, little do they care.
Once upon a time there was an investor. All of his life he was taught that, if you buy a stock and hold onto it forever, the stock will go up, you make a lot of money and live happily ever after. It’s the American dream. As we’ve come to learn, those dreams and Mother Goose have a lot in common. They’re fairytales. The harsh realities of the market have resulted in a rude awakening. The internet bubble, bear markets, and an abundance of corporate improprieties, have systematically demolished hordes of retirement accounts. The "buy-and-holders" are still "holding." Old habits die hard. Only, what they’re holding isn’t hard anymore.
Some folks have portfolios of stocks they might like to use a program of selling covered calls to generate some additional income. There are good and bad points to this strategy. Let’s start with an overview of covered call writing along with a basic example. Then, we’ll delve into the nitty-gritty of it.
Covered Call: The Stock
For our example, we’ll say you currently own 1,000 shares of Juniper (JNPR) trading at $21.30. How you came to own this stock is anybody’s guess. Maybe you bought and held, maybe you inherited it, maybe you won the lottery. It’s not really important. The question is ? how can you best use this asset to make money? You have a neutral to bullish outlook on JNPR. You project that it will trade flat or possibly up a little in the next few months. If your projection is just wishful thinking and you have nothing substantial to base your opinion on, you have no business owning a stock, let alone trying to trade options.
Covered Call: The Option
Well, if you’ve read my previous columns, you know that there is a bottomless pit of speculators out there. "Speculators" is the nice word. "Gamblers" is more accurate. There is, and will always be, someone out there who is willing to buy an option ? betting that JNPR will rise substantially in the next month. He is willing to buy the right to buy JNPR from you at $22.50 anytime between now and July expiration (about 6 weeks). For that right he’s willing to pay you $1.50 per share. That translates into $1,500 worth of dead presidents into your pocket.
The speculator is buying the JNPR July $22.50 call option. He’s buying the "right," but not the "obligation," to buy the stock from you at $22.50. He’s expecting that JNPR is going to appreciate well beyond $22.50. If he’s buying the stock at $22.50 and the option costs him $1.50, his breakeven is $24.00.
The nice part about all this is that the $1,500 he’s paying you is yours to keep ? regardless of what happens to the stock. It shows up in your brokerage account the very next business day. What you have to be willing to accept is the fact that, if JNPR does happen to move up, you’ve agreed to sell it at $22.50. You will not participate in any gains above and beyond $22.50. You are trading the upside potential for the immediate, and guaranteed, $1,500. See, everyone has his price.
More Profit Than You Think
Once you’ve accepted the possibility that your 1,000 shares may soon leave home, you can focus on the potential profit in the trade. If JNPR finishes above $22.50, there are two ways you will profit.
- You took $1,500 when you sold the call. That’s a good start.
- If your stock is called away at $22.50, you will have made another $1,200 in profit from the appreciation of the stock price. Remember, this all started with JNPR trading at $21.30. When the stock is sold, you get the $1,200 difference ($1.20 x 1000 shares).
You took in $1,500 from the sale of the option plus another $1,200 profit from the sale of the stock ? a total of $2,700. That’s a better than 13% return for a little over a month. If you used margin to purchase the stock, it would be about a 26% return.
If, at expiration, JNPR finishes below $22.50, you will still own the 1,000 shares of stock and, if you choose, will be able to sell another call for a future expiration cycle. In an ideal world, you would be able to repeat the strategy month after month. But, as we all know, we do not live in an ideal world.
The Good, The Bad & The Ugly
You now know the good. Get ready to learn about the bad and the ugly. The main risk in covered call writing is the fact that you do own the stock. And, contrary to popular optimistic thinking of the masses, the shares of JNPR could go down just as easily as it can go up. The $1.50 taken in from the option purchase provides a little cushion ? a damn little cushion.
The same principles apply to covered call selling as to all other trading and/or investment strategies. The main principle, and the toughest one to live with, is that you must have an established exit point ? and the self-discipline to act on it when necessary. Of course, that means having to admit that you’re wrong when JNPR turns south instead of going up.
How do you figure out your exit point? There are a few ways.
- Use a specific dollar stop. Your account management techniques tell you that you have a maximum limit of a $2,000 loss per position. That would dictate that you have to close out your entire position by selling your stock and buy back your short JNPR $22.50 option when it costs you a total of $18.90 ($18,900).
- Check for support levels. There may be a support level at $20.50. Maybe there’s a 50-day moving average at $19.55. You can establish an exit point if one, or both, of these support levels are violated.
Successful therapy takes hard work. So does becoming a successful trader. Unfortunately, we live in a lazy world. Rather than put forth a little effort, many people hand over life responsibilities and tasks to others ? then whine like spoiled children when the results aren’t what they wanted. The path of least resistance isn’t like the yellow brick road. It leads to the soup kitchen ? especially when it comes to taking care of your money.
We have discussed the basics of the covered call strategy. It’s not rocket science, which means Larry, Moe & Curly can do it. But, there’s more to it than meets the eye.
Covered call writing is a popular strategy. Why? Because it’s pretty simple. You own a stock. You sell someone the right to buy your stock. They give you money. Either the stock goes or it stays. Like I said, pretty simple. You can’t lose, right? If you believe that, you’re either an idiot or you’ve been listening to too many old Wade Cook tapes.
What Is A Successful Covered Call?
A successful covered call play results in your stock being called away. Some people really develop an emotion attachment to their stocks. Why? Beats me ? probably some form of mental illness But, if your stock is called away, don’t become depressed. Don’t take it personally. You haven’t been deserted. You shouldn’t suffer from separation anxiety. Your stock was a tool ? something you used to generate a little cash flow ? nothing more, nothing less.
Cost Basis For 1,000 JNPR Shares: $21,300
Premium Received For Selling $22.50 Call: $1,500 ($1.50 x 1,000)
Shares Called Away @ $22.50
Stock Appreciation (from $21.30 to $22.50) $1,200 ($22,500 – $21,300)
Profit For Option Cycle: $2,700 ($1,500 + $1,200)
Percentage Return for Approx. 1 Month: 12.67%
12.67% is one hell-of-a good return for one month. Just think, if you buy the shares on margin (don’t even think about it), your return would be over 25% for the month. The numbers above represent a best case scenario. That’s if everything goes just right. But, we know better than that, DON’T WE???!!!
You shouldn’t sell covered calls on stocks that you don’t want to have called away. Does that stop traders from selling calls on their favorite stocks? Of course not. When their precious stock is trading above the strike price of the short call, what can they do ? besides panic, of course?
Rocking & Rolling
If you believe your sold covered call is at risk of being exercised, you can buy the call back and roll it out for another month or two to a higher strike price. This, in effect, buys you more time and frees up the stock for more dollars of appreciation.
Using our previous JNPR example, let’s say you sold the near term JNPR $22.50 call for $1,500. The stock has moved to $24 and you believe it’s going to continue higher ? without you participating. The problem is that you’ve capped your potential profit when you sold the $22.50 covered call. With a few weeks left to expiration, there will still be some time value left (about $.50) in the $22.50 call along with the intrinsic value ($1.50). It might cost you $2.00 to buy back the option and free up your stock. You’ve just added $2.00 to your cost basis, but your shares of JNPR are free to run to the moon without any encumbrances.
Another alternative is for you to look at the next month’s JNPR (July) option chain and see that the $27.50 call is selling for $.50. You could sell the July $27.50 call and take in the $.50, thereby covering the extra $.50 of time value you spent to buy back the June $22.50 call.
So, let’s do the math. You just paid $2.00 to buy back the $22.50 call. Now you’re selling the $27.50 call for the following month for $.50. That means you are still $1.50 out of pocket ($2.00 less $.50). But, are you really out of pocket? JNPR is now trading at $24 ? that is $1.50 above the $22.50 strike price. Basically, what you’ve done is to add $1.50 to your cost basis for the stock. But, now JNPR can move up to $27.50 and you will participate up to that level.
Looking back at last week’s column, we see that the original cost basis for your shares of JNPR was $21.30. Now, it is $22.80 ($21.30 plus $1.50). Again, the $1.50 comes from the $1.50 that JNPR is trading above the $22.50 strike price, plus the $.50 you received for selling the $27.50 call and minus the $.50 of time value you paid for when buying back the original $22.50 call.
When selling the $27.50 call, you would again be taking on an obligation to sell your JNPR shares ? this time at $27.50 ? in about six weeks. As JNPR continues to move up, you can repeat the process. Additional option premium may not always be there, but at least you’ll still own your precious stock.
A Marriage Made In . . . ?
Fact: Many brokerage firms only allow covered-call selling in IRAs. Fact: There are still countless buy and holders who are still holding stocks in their IRA. It’s fate. It’s inevitable that the twain will meet. The money or the stocks will eventually disappear and the novice traders will have more bad things to say about options. They will continue to live in denial. It wasn’t their fault. They’ll blame the options — when they simply don’t know how to use them. When all is said and done, the only way to own a stock is to buy a protective put as insurance to protect against catastrophic events.
For those of you who are chomping at the bit to start trading, hang in there. There is a lot more to know about these covered calls ? and we will go over it thoroughly in the next article.