In yesterday's edition of Advanced Options, we broke down the basics of covered calls, which is a relatively conservative strategy often used to limit the risks of stock ownership and collect potential premium on stagnating securities. Today, we're going to make this strategy even more tangible by dissecting a hypothetical covered call on a popular security: TASER International, Inc. (TASR: sentiment, chart, options).
Briefly recapping what we learned yesterday, a covered call is best initiated on a stock that meets the following criteria: is already in your portfolio, will likely remain relatively stagnant in the near term, and you're comfortable parting with if necessary. However, avoid stocks that you're very bullish on, as you don't want to say 'sayonara' to an equity with mucho potential for long-term gains. The primary goal is usually to earn some extra income on the security, or to provide a limited amount of protection against a possible pullback in the short term.
How does it work? Once the underlying stock has been selected, the option trader sells a near-term call on the security, 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. Simply put, the covered-call writer wants the underlying security to remain as close to the strike price as possible without going over by options expiration.
That being said, let's pretend that we bought 500 shares of TASR in November 2008, when the equity was flirting with the $3 level. Though we have high hopes for the security in the long term, the stock has been somewhat lackadaisical on the charts lately. In fact, since October 2008, the equity has sluggishly slithered between support in the $3.50 neighborhood and resistance in the $5.50 region. Plus, further hindering TASR's technical progress has been its stagnating 10-month moving average, which hasn't been breached on a monthly closing basis since late 2007.
Against this backdrop, we think the shares of TASR will remain relatively subdued in the next few weeks. As an attempt to generate some extra income in the near term, we opt to sell five TASR June 5 calls (one call for every 100 shares), which last crossed the tape at $0.10. Our total premium received would then be $50 ($0.10 x 100 shares x 5 contracts), which we would pocket up front.
If TASR remains below the $5 level by June options expiration, our calls will expire worthless; we then get to keep the $50, as well as our 500 shares of TASR.
However, let's say the security takes an unexpected turn for the worse. Our breakeven level would be $2.90, which is the original price of the stock ($3) less the premium received ($0.10). In other words, the shares of TASR can tumble all the way to the $2.90 level before we incur a loss on the position.
With that in mind, let's say the equity cascades beyond our breakeven point, falling to the $2 level. The good news is that our calls will expire worthless and we can pocket the $50. The bad news is our portfolio just took a significant hit, as the value of the stock is now down a dramatic 33% from our original purchase price of $3.
On the other hand, let's say the shares of TASR suddenly skyrocket to the 7 level, powering past our strike price of 5. In this case, our calls would be assigned, obligating us to sell our 500 shares of TASR for $2,500 (strike price of 5 x 500 shares). We've now rid our portfolio of all things TASR, and missed out on a sweet 40% gain in the stock price. Our original premium of $50 helps a little, along with the gain over the original $3 purchase price, but not nearly enough to cushion the entire blow.
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