Victor Greco, DiscoverOptions Chief Options Strategist
Have you noticed that when markets go up, you always hear from your investment advisor? How often do you hear from them now? With the dramatic drop in the wealth of the average American this past couple of years you naturally wonder whether all this pain could have been avoided or, at the very least, been made a lot less painful.
In fact, most individuals who where hoping to retire within the next few years have started to search through the want ads in order to secure a part time job, feeling that would be the only way to provide the extra income they need in retirement.
However, I am here to tell you that if you had more knowledge on the types of investment vehicles and the inner workings of the markets, then you would be able to make wiser investment decisions. The covered call is one strategy that allows you to make that extra income without having to become a greeter at Wal-Mart.
Knowing our readership, I am confident that virtually all of you have purchased stock in the past. And chances are that many of you are still holding those very same stock positions. I also have the feeling that many of you are not happy with the current prices on your stocks. I also know we agree that the main reason you bought them in the first place was to increase your financial position. TO MAKE MONEY!
There are two things that motivate investors….FEAR and GREED! Successful investors strive to achieve a level of discipline which removes these two factors from their thought process and allows them to make only sound, wise investment decisions.
Having said that, what if I told you that you can increase your monthly income and reduce the risk on your stock purchases at the same time, all without being encumbered by emotions. Would you be interested?
Well then you are in luck because that is exactly what I'm going to teach you today!
First let's look at the definition of an option contract:
Option Contract: A contract which gives the buyer the right, but not the obligation, to buy or sell a specified quantity of a stock (usually 100 shares) at a specific price (the strike price) within a specified period of time (by the expiration date). The seller of the option has the obligation to sell or buy the stock (depending on whether it is a call or put option) from the option buyer at the exercise price if the option is exercised.
All professionals in the financial community know about options, because they need to if they want to pass their licensing exam and get a job in the industry. But only the wisest of them actually use them. Options are a subject which, once mastered, allows you to have a better chance of making money no matter which way the market moves.
We need to know what a covered call is exactly, so let me give you this definition: The covered call is a strategy in which an investor writes/sells a call option contract while at the same time owning an equivalent number of shares of the underlying stock.
Benefits of Covered Call Options
- You can increase your monthly income…. because if you sell something you are getting money for it.
- You can reduce your overall cost…. because if you are not required to sell your stock, you can apply the amount received to lower your cost basis.
- You can increase your overall yield on your investment… when done correctly the covered call strategy will yield a higher percentage return.
So when you sell call options against your stock positions, it enables you to capture some great benefits that other buy and hold investors are not getting!
Example 1: GE Covered Call
Let's look at what we would do in order to initiate a covered call with 100 shares of GE as the underlying security. We purchased 100 shares of GE at $6.65 per share for a total investment of $665. Then we sold 1 March $6 Call and received $125 for doing so. The March options will expire in just 17 days.
The $125 we receive for selling the call option is called the Premium and it will help to offset the cost of our GE shares. We only have to pay $540 for the entire transaction, letting us keep the extra money in our account. The profit/loss graph for this position looks like this:
Since you own the underlying security, this transaction is considered covered and your risk exposure has been reduced compared to if you owned the stock outright. The great news is that no matter what happens to the price of GE, we get to keep the premium!
Remember that each option contract represents 100 shares of the underlying security. Therefore, selling one call option against the 100 shares of GE represents a covered position because if I was called to sell the shares, I have them to deliver.
If GE closes below $6.00:
- You keep your 100 shares of GE
- You keep the premium of $125
- That premium represents an 18.8% return on the stock
If GE closes at (or above) $6:
- You sell 100 shares of GE at $6 per share
- You lose $65 on the stock
- The additional premium represents a 9% return on the stock
Let's walk through if GE closed below $6.00 per share. You would retain ownership of your GE shares as well as the premium you received when you sold the option contract. This outcome still gives us an additional $125/$665 = 18.8% return on our investment you would not get if you simply held the stock itself. Pretty cool, wouldn't you say?
But what happens if GE does close above $6 per share? Remember, we purchased the shares at $6.65 per share, and this will result in us having to sell our shares of GE for $6 per share giving us a loss of $0.65 per share or $65.00. That doesn't sound good does it?
Did we forget something here? Yes! Don't forget that you still get to keep the premium of $125. So the numbers work like this…… We paid $665 for 100 shares of GE but received $125 in premium. The additional $60 in premium we received after subtracting the $65 loss on the stock is still a 9% return on that $665 investment.
Take a look at the graph above once again and notice that the total covered call position cost only $540 to put on. When GE closes above $6 we make a $60 profit - giving us a total return of 11% in less than 3 weeks!
You just found out how you can actually make money no matter which way the markets move! How would you like to make this kind of return each and every month?
Example 2: ROH Covered Call
One of the tools I use to find trading opportunities is called OpScan, and it is available within the OptionVue 6 software. It allows me to set parameters and to analyze all the option opportunities currently out there within my stated parameters. Below is an example of a scan for the highest yielding in the money calls.
OpScan is an amazing tool, allowing you to scan the entire market in just seconds. Once this list is generated, I scan over the potential candidates and choose a company that I may be familiar with that is also in a price range I can afford.
In this case, I chose Rohm and Haas. As you can see, it indicates that the last trade was at $52.90. That would mean that I would be buying 1000 shares of ROH for a $52,900 investment (all these examples assume you are NOT buying on margin, which would roughly double your yield).
It also shows that there are only 19 days left until option expiration. Remember that is the date as which the option buyer has to request that I sell him my shares. After that, his right to buy from me is forever gone.
Once I have chosen an opportunity, I move over to the next step in the process….looking at the price chart to see where it has been in the past.
This is a candlestick chart on ROH, and I have put in a couple of trend lines to help us with a possible range of future movement. I am looking at this chart in order to ascertain any additional information that would sway my decision. There are many different charting tools that can be utilized.
We see that within the last year, ROH has never been as low as $40.00 per share. This makes me a little more comfortable knowing that the covered call trade I am considering has a higher probability of giving me the desired results. After I feel confident enough about this trade, I would send the order to execute it. At that time the stock was trading at $52.85 per share, while the March 40 calls had a Bid price of $15.37.
Now that we have established this position, let's take a look at how we will do if we hold it to option expiration. As a general rule, most stock options expire the third Saturday following the third Friday of the expiration month.
Looking at the Outcomes
If ROH closes above $40 on the March option expiration:
|You sell 1000 ROH at $40 ||$40,000|
|You keep the premium received ||15,370|
|Total Credit ||55,370|
|Less Cost of Stock ||52,850|
Even though we now have taken a loss on the sale of our stock, we need to take into consideration that we took in $15.37 per share in premium. This was like selling a partial stake in the stock 3 weeks ago. We are now collecting the other portion that is owed us. When we add the two amounts we received, our total credit into our account will equal $55,370.
The difference between our original stock investment of $52,850 and the credit we just received of $55,370 gives us a profit of $2,520! We just made a 4.8% profit in 19 days!
So we just learned how investors make money when the market goes sideways or remains stagnant. When do you remember making a 4.8% return in 3 weeks with very little risk? But you might ask, what happens if the stock takes a nose dive? After all, that seemed to happen a lot this past year.
If ROH closes below $40 on the March option expiration:
|You keep your 1000 ROH ||$52,850|
|You keep the premium received ||(15,370)|
|Net amount ||$37,480|
Let's say the shares of ROH dropped from $52.85 per share to $39.00 over those 19 days. At expiration, this is what will happen. Your call option will expire worthless and your stock will NOT be called away. That means you get to keep the original 1000 shares you purchased. You will also, as always, get to keep the premium you received when you first sold your 10 contracts. So your actual cost is now only $37.48 per share.
Given the above scenario, what might you do now?
If it were me, I would go ahead and sell another 10 call contracts against the stock position. At this juncture, depending on how you felt about the prospects of ROH, you may have to decide whether to sell more in-the-money call options, or consider whether it might be better selling out-of-the-money calls. The decision will be yours to make, but that's what education is all about. Gaining the necessary knowledge and being able to understand it.
Buy and Hold. Asset Allocation. Most all of you have heard these being touted at some point or another, right? And there is some merit to them. But these strategies all have one flaw in common…..They are strategies that work well in bull markets when everything is going up. The problem is that they work very poorly in bear markets, or when everything is going down.
With that in mind, for those of you that are interested in receiving a comprehensive understanding of the benefits of covered call investing, consider our new Discover Covered Calls Education. This is a professionally made learning tool that will teach you all you need to know about this conservative way to increase your monthly income and to help reduce your risk.
Using the covered call strategy is NOT a get rich quick scheme. I am not touting that you will make an 800% return on one trade as others may claim. But it can be used to generate additional income in all types of markets. And what I am suggesting is that if you make an investment in your financial future and get the education you need, you will be a wiser investor which will enable you to enhance your financial future.
Take the first step toward rewarding yourself with an education that can change your financial future forever. Start your journey today. Don't let yourself be worried about the ups and downs of the market ever again. Don't let emotions like fear and greed control your investment decisions……become a WISE investor! Don't let the minimal fee of $299 stop you from creating and maintaining your financial dreams and goals.
INVEST IN YOURSELF TODAY!