Selling Covered Calls
Selling covered calls is a technique used by many investors to increase their income yields on a given stock, and also to give them downside protection. Many investors immediately run away when they hear the word options, because they've been burned in the past by buying call or put options, figuring it was an easy money strategy.
The big secret about options that the financial press doesn't often write about, is the fact that 3 out of 4 options expire worthless. That's right, as a buyer of options, you only have a 25% chance of making money.
Time Decay: The Essential Options Ingredient
The way to consistently make money with options, is to not be a buyer, but rather, a seller, of options. Why is this so? Because, when you become an option seller, you'll have a very important factor, "time decay", or "theta", working in your favor.
Here's how time decay works: When you buy a call option, you're making the bet that the underlying stock is going to rise to or above a given price, by a specific date, known as the expiration date. The inverse would be true for buying put options - you're betting that a stock is going to decline to or past a certain price by a specific date. So, not only do you have to guess the stock's price direction correctly, you have to do it within a given time period. Even worse, as the option nears its expiration date, its time value starts to decline.
That's why, as a seller, you've got the odds stacked in your favor. In fact, option sellers often guess the direction of the market, or a stock incorrectly, but they still win, due to the factor of time decay and the expiration date. If you've bought options, I'm sure you've experienced the frustration of being right about a stock, after your option has already expired worthless.
Puts and Calls: Option Definitions
Call option: An option contract that gives the owner the right to buy the underlying security at a specified price (its strike price) for a certain, fixed period of time (until its expiration). For the writer of a call option, the contract represents an obligation to sell the underlying stock if the option is assigned. Each Call option contract normally corresponds to 100 shares of the underlying stock.
Call Bid Premium: The current price that call buyers are offering for a given call option. The premium bid price times 100 is the amount of money that a call seller will receive for each contract sold.
Covered call / covered call writing: An option strategy in which a call option is written against an equivalent amount of long stock. Example: writing 2 XYZ May 60 calls while owning 200 shares or more of XYZ stock.
Covered Call Yield: Calculated by dividing the Call Bid Premium received by the price of the underlying stock.
Covered put / Covered cash-secured put: Cash secured put is an option strategy in which a put option is written against a sufficient amount of cash (or T-bills to pay for the stock purchase if the short option is assigned).
Put Bid Premium: The current price that put buyers are offering for a given put option. The premium bid price times 100 is the amount of money that a put seller will receive for each contract sold. (Also see Bid/Bid Price).
Put option: An option contract that gives the owner the right to sell the underlying stock at a specified price (its strike price) for a certain, fixed period of time (until its expiration). For the writer of a put option, the contract represents an obligation to buy the underlying stock from the option owner if the option is assigned. Each Put option contract normally corresponds to 100 shares of the underlying stock.
Put Yield: Calculated by dividing the Put Bid Premium received by the Put Strike Price.
Strike Price: The “resale” price on an option contract, the price at which an option buyer or seller agrees to buy or sell the underlying shares if they’re assigned to him, or exercised by him.
Option Chain: The various expirationmonths of option contracts available for a stock.
Expiration Date: The date on which an option contract expires. For American options, this is the third Friday of the option's expiration month.
Assigned (an exercise): Received notification of an assignment by The Options Clearing Corporation. When selling covered calls, if the underlying stock’s share price has risen beyond the value of the strike price plus the call premium received by the seller, his shares will be sold, (assigned), by his broker at the sold call’s strike price, usually at or near the expiration date.
Static Yield (Calls): The call option premium amount divided by the underlying share price. Static Yields occur when, on or near the expiration date, the underlying shares do not rise above or to the price represented by the call strike price plus the call premium. For example, if you sold a $25 call contract for $2, the underlying share price would have to rise to or past $27.00 to trigger an assignment of your underlying shares. If this doesn’t happen, you’ve achieved a Static Yield.
The Greeks, and How They Can Help You Make Money
When option traders refer to "the Greeks", they're referring to the Greek letter names that are used for certain characteristics of options. The 2 most commonly utilized "greeks" are:
Delta: Measures the change in an option’s price resulting from a price change in the underlying stock. Puts have a negative range, (-100 to 0), and calls have a positive range, (0 to 100).
Theta: A term used to describe how the theoretical value of an option 'erodes' or reduces with the passage of time.
Volatility - It's Not Always A Bad Thing
The word "Volatility" has a negative context in most situations - we think of a "volatile" person as someone we'd want to avoid, etc.
However, in Options trading, Volatility can be your friend. Here's why:
There are 2 types of volatility: Historic Volatility and Implied Volatility.
Historic Volatility measures a stock's price changes over a specific period of time. It's usually half of the equation that you'd want to pay attention to, when looking at a stock's volatility. Why?
Because Implied Volatility is the market's current measure of a stock's recent price changes. Specifically, if a stock has a few days of larger than normal price swings, this can alter its implied volatility, which will, in turn, often increase the premiums on its options. This occurred in the extreme in the 4th quarter of 2008, as volatility shot up to unprecedented levels.
The overall volatility of the market is measured by a figure known as the VIX, appropriately known as, "the fear factor". In Q4 2008, the VIX rose up into the 80's, from its previous level in the 20's. Conversely, when the VIX gets down into the low teens, contrarian investors use this as a bullish signal.
It's a good idea to look at both historic and implied volatility and compare them. Often, a high-profile stock's implied volatility may be totally overblown, compared to its historic volatility, causing its option prices to become inflated. This can often be the sweet spot for option sellers, and this is where Theoretical Value Pricing Models enter the picture.
Most options trading platforms will have an options pricing model, such as Black-Sholes, that will give you the theoretical value of an option, thereby indicating if it's under- or over-valued. This isn't the final word on whether or not you should sell an option, though. That really depends upon your outlook, and your yield and cash parameters.
How to Sell a Covered Call
Selling covered calls normally requires more cash than buying call options, since you must own the underlying stock that the call option corresponds to, before you sell the call option against it. (I don't recommend selling "naked" covered calls, as your loss potential is unlimited.)
IMPORTANT: Each option contract corresponds to 100 shares of the underlying stock.
Here are the steps in a trade example. We'll use DOW as our trade example:
1. Buy 100 shares of DOW, which closed at $21.53 today. Cash outlay: $2153.00
2. Sell 1 Jan 2010 $22.50 call contract, (symbol DOWAX), which closed today at $2.15 bid. This puts $215.00 cash back into your account, reducing your cash outlay to $1938.00
3. Collect $.30/share in dividends before the January expiration, ($30.00)
When the January 15, 2010 expiration date comes, there will be 2 possible outcomes:
1. Assignment: If DOW rises to or above $24.65 near or on the expiration date, your 100 shares will be sold/assigned at the $22.50 strike price, giving you an additional $.97/share profit, ($97.00).
2. Static: If DOW doesn't rise past $24.65, (the $22.50 strike price plus the $2.15 call premium), you'll keep your shares, at a new lower non-tax cost basis of $19.08, which was your breakeven on this trade.
Analyzing Covered Call Yields
In the above example, we sold covered calls against DOW Chemical, a stock that cut its dividend this year, and only yields 2.79% annually. During the term of this trade, you'd collect just $.30/share in dividends.
However, by selling the January 2010 $22.50 covered calls, you'd collect an additional $2.15/share, over 7 times the amount of the dividend payout.
Sound too good to be true? It's not, but there is a catch: No matter how high DOW may rise, you're obligated to sell your shares at $22.50. In essence, you're taking your profit now, and betting that the stock won't go through the roof, or, you may be betting that it might decline, and you want to protect yourself against loss of principal.
The $2.15/share in call money and $.30/share in dividends you collected give you an 11.38% "Static Yield", which is also your downside protection in a covered call trade.
The additional $.97/share you'd collect if the shares are assigned would give you an additional "Assigned Yield" of 4.5%.
Your "Total Potential Assigned Yield" is 15.88% on this approximately 6-month trade. Not a bad yield for a 6 month - it sure beats less than 1% on T-bills, eh?
Covered Call Strategy and Timing
Many investors will sell covered calls when they become convinced that the market is overdue for a big correction. They reason that their stocks' prices will probably decline in the near future, so they sell calls to hedge against some of the price decline, and, of course, to earn extra income.
Other investors use this strategy as a short-term, (less than 12 months), income-generating strategy, in effect turning their stocks into short-term bonds. They've decided to grab their cash yields today, instead of waiting and hoping for future price appreciation.
Indeed, that's one of the best features of selling covered calls: You get paid the call option premium money within 3 days of the trade. So, if you want to raise cash, and you own stocks that are optionable, you can earn cash almost immediately by selling calls against them.
Another attractive feature of this strategy for many investors is that they know exactly what their upside potential is, in addition to having a lower break-even point.
This strategy becomes especially interesting when used with high dividend stocks, as the combination of high dividend payouts and call premiums combines for some very high cash yields.
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