Last week I wrote a little about calls. I defined them and showed
how they could be used in place of a stock to try to profit on a rising
stock. The article generated quite a lot of interest so this week, I'll
address another bullish strategy using calls.
This strategy is bullish and is one of the more common uses of call
options. It is known as writing covered calls. In stock lingo
writing means selling. Covered means you own the underlying stock,
and you already know what a call is from last weekend's article.
Let's use an example that existed during the past week. When NYSE
Group (NYX) was trading around $62.90, the Jul 60 calls were trading at
$4.50 x $4.80 while the Jul 65 calls were trading at $1.95 x $2.10. If
we're going to write covered calls, we need to own at least 100 shares
of the stock since a single option contract controls 100 shares of stock.
In case you are unfamiliar with option quotes, you'll see that
there are two prices, the bid and the ask. The bid (lower number) is
what someone (often the market maker) is willing to pay for the option
and the ask (higher price) is the price at which someone (often the same
market maker) is willing to sell the option. The difference between the
bid and the ask prices is called the spread. In our example on NYX, you
can see that the spread on the July 60's is 30 and the spread on the
65's is only 15 .
Back to covered calls. Suppose it looked like NYX was moving up.
We could buy the stock for $62.90 a share and simultaneously sell calls
against the stock (known as a buy/write when we do both at the same
time). Suppose we decided the stock looked very strong and we decided
to buy the stock at $62.90 and simultaneously sell the Jul 65 calls for
$1.95. Since option contracts usually control 100 shares of stock, we
would have to buy at least 100 shares of stock to sell 1 contract of
call options. In this case, let's say we decided to buy 100 shares of
the stock for $6,290 and sell 1 contract of the July 65 calls for $195
(100 shares x $1.95) our net debit would be $60.95 ($62.90 minus $1.95)
so we would only have $6095 out of pocket since the market is giving us
$1.95 a share for the calls. Now what is the situation? Well, we own
100 shares of NYX, but since we sold the Jul 65 calls, we are obligated
to sell our stock at $65 a share if called anytime before July
expiration. Since the stock price is less than the strike price of the
call we sold, we sold an "out of the money" call in this example. If
the stock doesn't get above $65 before expiration what happens? Well,
we get to keep the stock because no one is going to pay us $65 a share
if they can buy it cheaper on the open market, and we also get to keep
the $1.95 a share premium we got for selling the call. What if the stock
is more than $65 at expiration? Well, we'll most likely get called out
(assigned) since the call buyer can now buy the stock from us for $65
and immediately turn around and sell it for whatever price the market is
then paying. Of course, we still got to keep the $1.95 a share call
premium AND, we have sold a stock we bought at $62.90 for $65 thus
adding another $2.10 a share to our profit. If we don't get called out,
we made $1.95 a share on our $62.90 stock or about 3% for less than a
month. If we do get called out, we make the $1.95 premium PLUS the
$2.10 a share profit for a return of about 6.4% for less than a month.
Of course, commissions are paid on the transactions so we need to be
aware of that cost.
Instead of selling the "out of the money" call, we could have
chosen to sell an "in the money" call. For example, with NYX at $62.90,
we could have bought the stock and simultaneously sold the Jul 60 call
for $4.50 a share. Now, our out of pocket would be $62.90 - $4.50 =
$58.40 or $5840 for the 100 shares. Suppose the stock stays above 60
(the strike we sold) to expiration. Well, we'd be called out at $60 a
share, wouldn't we? But we paid $62.90 a share so we're going to lose
$2.90 a share. So what, the market gave us $4.50 to sell the call and
now, we're only giving back $2.90 of that $4.50. We KEEP $1.60 a share
even if the stock drops almost $3 from where we bought it. That's less
than a one month return of 2.5%!
Buying stock is always risky. The risk is what we pay for the
stock because theoretically, at least, the stock could go to zero. So,
when we buy a stock and also sell a covered call, our risk is always
less than it is if we bought the stock alone. The market has paid us to
sell the call and our risk is reduced by that amount. Some traders and
investors sell calls against their portfolio quite regularly and can
thereby enjoy reduced risk and a monthly return on their investment. Of
course, if we sell a covered call, we are obligated to sell the stock at
the strike price we sold. In our example, suppose NYX went to $100 a
share and we had sold the 60 call. Unless we had taken some action to
buy back our call, we'd have to sell the stock at 60 if called (and we
certainly would be). So, when we sell covered calls, we are giving up
some opportunity to the up side if the stock runs. If we're afraid to
lose that chance, writing covered calls isn't for us. If we want to
reduce risk and create monthly income, it is a strategy worth learning.
Good Trading!
Bill Kraft
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