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Advanced Options: Contemplating Covered Calls

Weighing the pros and cons of covered calls

by 5/6/2009 3:30:28 PM
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In last week's edition of Advanced Options, we explored the exciting world of collars, which can often help protect gains on a stock already in one's portfolio. In this week's column, we're going to stick with the "already own the underlying stock" theme by dissecting covered calls.

(While this series is geared primarily toward the seasoned option speculator, rookies can check out its new sister column, Options 101, which introduces readers to the basics of options investing.)

Do you own a stock that you think will remain relatively stagnant in the near term? Are you neutral-to-bullish on the stock's long-term prospects, but are willing to part with at least 100 shares of the equity if need be? If so, a covered call strategy could potentially generate additional income on the position, and/or provide a limited amount of protection against a decline in the underlying stock price.

How does it work? Simply put, an option trader sells a call on stock he or she already owns, pocketing the premium. If the stock remains below the strike price of the call by options expiration, the option will expire worthless and the trader can keep the premium.

If the underlying stock rises above the strike price before expiration, the call will likely be assigned, obligating the trader to sell 100 shares of the security for the strike price of the option. In other words, the investor now has to sell 100 shares of an uptrending stock at a discount to the current market price. The trader pockets a small profit, but now limits his or her participation in a significant rally.

Meanwhile, if the underlying stock takes a dramatic hit before expiration, the investor's portfolio also takes a notable hit, considering he or she still owns the shares. However, the profit from the sale of the call can help offset at least some of these losses.

Let's break it down even further.

Sally recently purchased 100 shares of Stock ABC at $28. She thinks the long-term outlook for the security looks good, but has a feeling the shares are going to remain somewhat subdued in the near term. So, Sally decides to initiate a covered call on the stock.

Considering her expectations for the stock to stagnate in the near term, Sally opts for a June-dated call. She considers the 30 strike, as she'd be comfortable parting with the shares of ABC for that price, should the option get assigned. Plus, she doesn't think ABC will hit or surpass the 30 level by June options expiration.

With this in mind, Sally decides to sell an ABC June 30 call, which is currently asked at $1. Considering each option contract represents 100 shares, she would receive $100 in premium up front. The breakeven for this position would be $27, which is the stock price at initiation less the initial credit received.

Now, there are a couple of different ways Sally's position could play out...

Let's say the shares of ABC are trading around $29 below the strike price when June-dated options expire. Her ABC June 30 call will likely expire worthless, allowing Sally to pocket the $100 and continue holding the shares of the stock. In other words, Sally is capitalizing on time decay, which is an enemy of the option buyer, but a friend of the seller.

Now, let's say Stock ABC took a turn for the worse, plummeting to the $22 level below the strike price by June expiration. The good news? The call will expire worthless and Sally can pocket the premium. The bad news? Sally's 100 shares of ABC are now worth more than 20% less than what she initially paid ($28).

On the other hand, let's say Stock ABC skyrocketed to the $35 level by June expiration. The stock will likely be called away, obligating Sally to sell 100 shares of ABC for $30 each. On the plus side, she's "covered" since she already owned the shares prior to selling the call. And, she'll make a small profit over the $28 purchase price. But, if Sally hadn't sold the June 30 call, she could've unloaded her 100 shares of ABC for $35 each. Plus, if the security continues to rally, she's now missed out on any additional gains.

In conclusion, the covered call is a relatively conservative strategy, used to limit the risks of stock ownership and collect potential premium on securities from which you don't expect a lot of volatility. However, as with any options-trading strategy, it's best initiated after studying the potential risks and rewards.

It's here! Click here to check out "Bernie Schaeffer's SENTIMENT, smart options for today's investor," a new quarterly magazine devoted to the subject of options trading. SENTIMENT'S inaugural edition includes a cover story by Bernie -- "Are We There Yet?" -- that arms readers with some new tools for gauging a market bottom. Every issue of SENTIMENT will include advanced strategy stories to help experienced traders build their portfolios, along with educational pieces for the relative newcomer.

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