Selling covered call options basics
The question then becomes, why aren't more people making fortunes with options? The simple answer is time, which is the other extremely important thing to anyone who dabbles in the options market. Time is the limitation on your leverage. Once the contract expires, you no longer have control over those one hundred shares.
When it expires, you no longer have the right to purchase one hundred shares at a particular price. Well, when the call option expires, the person who sold you that call option gets to pocket the one hundred dollars and no longer has any obligation to you.
That premium is the reason people are willing to write sell a call option. Which brings me back to the reason that time is one of the major determining factors when dealing with options.
With enough time, and assuming the company continues to grow, the stock price will eventually appreciate and surpass your break-even point. Then the leverage would kick in and you would have your fortune. The problem of course is that you have at most nine months for that stock price to appreciate and the longer the time frame that you have, the higher the premium that you're going to pay to control those one hundred shares. The price that you pay for the premium, which is the price you pay to have the right to buy one hundred shares at a specific price, is made up of two components, intrinsic value and time value.
Intrinsic value is the difference between the strike price and the current price. The other part of the premium is the time value. Time value is the cost you pay to compensate the person who wrote the call to give up the potential gains of the stock before the option expires.
Paying the premium gives you control over one hundred shares of stock for each contract you buy. While leverage and the possibility of massive returns is the most common reason people buy options, there are several other reasons that I'll quickly go over.
The first reason is that someone might want to lock in the current price of a stock, doesn't have the money to buy the shares outright but will receive the money to cover the cost of the shares in the near future. Another reason, one that is most commonly found when rumors are floating around about a company, is that a person thinks something is going to happen, such as a new blockbuster drug approval, which will cause the stock price to shoot up.
They don't want to buy the actual shares because the company happens to be a one hit wonder and if the drug is not approved, then the stock price may fall significantly. By purchasing a call option, the person sets themselves up to profit greatly if the drug is approved while still greatly reducing their downside risk if it is not approved. The Seller of Options So have I talked you into putting your entire retirement account into out of the money call options?
Because if you're wrong about the direction of the stock or how long it'll take to go in that direction, then you just lost the entire investment. With that cheery thought, let's take a look at the other side of the option transaction which is the person who writes sells the contract and promises to deliver one hundred shares at a specific price in nine months if you choose to exercise that option during that time.
In return for guaranteeing you that particular price and giving up the possible gains for that particular time period, all they ask is for a little compensation. Does it sound like the person writing the call has been cheated?
Stay with me because it's possible for the person writing a covered call to have fairly consistent gains The difference between writing a naked call and writing a covered call is the difference between owning one hundred shares of the stock which you've promised to deliver at a specific price and not having those shares.
When you write a naked call, you are exposing yourself to limited gain and unlimited loss. For example, if you write a naked call you will receive a premium which will probably be a couple hundred dollars per contract. That couple hundred dollars is the most you can make. As long as the stock price stays flat or decreases you'll have no worries and the couple hundred dollars will go straight into your pocket. Unfortunately, if the stock price goes up, you are exposed to unlimited loss.
A covered call on the other hand will cap your maximum loss. The maximum loss on a covered call writing strategy is defined as the cost of the one hundred shares of stock minus the premium received. That is assuming the company went bankrupt and the stock price did an Enron. Aren't we all taught that you want to use a strategy where your maximum profit is a large multiple of your maximum loss? It's a fair question and now you know the risk of the strategy.
Of course, there are a couple reasons why someone would employ such a strategy. The first one, and the most common, is that people want to gain a little extra income from the stocks they own.
Say you have one hundred shares of ABC, a "blue chip" stock. Many people rely on the large, safe company for their quarterly dividend so they can have a little extra income. Obviously, the people who own ABC are hoping for some price appreciation with that dividend, but they're expecting slow, steady growth and are planning on holding onto the stock for a very long time. What if they wanted to increase their annual return in a fairly risk free way?
Well, they could write a call option on their one hundred shares. If you write two of those per year and add the quarterly dividend to it, you've created a twelve percent return for the year even if the stock price stays at the same level. So, a twelve percent return if the stock price goes nowhere. And that's the great part about covered call writing: Are you impressed with twelve percent? On a safe stock like ABC? How about another example, maybe something a little riskier?
To figure out the percentage yield on this example, you divide the premium by the current price. So in five months you would yield eleven percent. Since it was only for a period of five months it means you can do that twice per year which would yield a total of roughly twenty-two percent.
Before anyone starts getting blinded by the dollar signs, does anyone see the flaws with this plan? Time and the break-even point. The two things that are important to every person who plays in the options market. It doesn't matter what side you're on, time and the break-even point affects you.
For the person who's trying to generate some decent returns, when they write a covered call they're hoping that the price of the underlying stock either stays flat or goes up. It doesn't matter which, although you will be a little happier if it stays flat because it means you were smart enough to make money without the stock price moving, but it really doesn't matter which one it does. The one thing you don't want to happen when writing a covered call is to have the stock price go down.
Sure, you're guaranteed to collect the premium, but the underlying value of the stock that you're holding has now decreased and you could end up with a net loss. And if we remember Warren Buffett's first rule of investing: The longer the timeframe, the higher the probability that something will happen to cause the stock price to decrease.
And when the stock price decreases, you lose money. So how do you mitigate some of that risk? Write a covered call that expires in a month or less. If you do the math on that, you'll see that you would yield three percent. The sale of a Covered Call option obligates the seller or writer to deliver stock at the strike price of the option if the option buyer chooses to exercise his or her option.
The term "covered" refers to the fact that the option writer's obligation is covered by ownership of the underlying stock. For assuming this obligation, you are paid a premium at the time you sell the call. Let's look at the FREE data offered on the www. You may choose the highest Percent Return Premium Covered Call option or you may want to choose another option in the listing and do some research to identify the strength of the underlying stock.
This will take you to Profile, Research, News and Chart information of the underlying stock. For example, if you choose a Covered Call candidate that is 30 days out, you would select 12 Cycles Per Year. Because every on-line brokerage order entry screen is different, you will need to consult with you broker for instructions on placing Covered Call orders on-line.
The Covered Call writer can take one of two approaches to writing a Covered Call: Sell call options against stock that is already owned.