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| Options Education |
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If you were walking and saw a $10 bill on the sidewalk,
would you continue walking right past it? |
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Of course not. You would stop and pick it up!
There are option strategies that incorporate this trading mentality. |
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| TARGETING CONSISTENT PROFITS |
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One of the biggest mistakes made by option traders is to try to
capture wealth by using overly aggressive trading strategies. However, instead of lining their pockets,
they often end up losing their pants.
Although speculative option strategies can be very exciting and do have tremendous profit
potential, it is often the conservative strategies, such as covered calls, that achieve profits
on a more consistent basis and add significantly to the bottom line.
In this article we are taking a closer look at one of the simplest and arguably safest
option strategies - Selling Covered Calls.
Selling covered calls is considered to be safer
than buying individual stocks because the premium received from selling the covered calls
provides a safety cushion in case the underlying shares decline.
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Selling Covered Calls can be like picking money up
from the sidewalk.
You won't get rich overnight, but your wealth grows each time you do it. |
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THE BASICS OF SELLING COVERED CALLS
(Investors who are experienced with covered calls may wish to skip to Section II)
The Covered Call Strategy is one of the easiest strategies for new option investors because selling
covered calls is an extension of owning stock. Even the most novice investor should be familiar with
the objective of buying a stock and selling it for a higher price on a later date. The Covered Call
Strategy takes this process one step further by defining the selling date and price.
Let's look at an example:
Investor Dave owns 100 shares of XYZ stock and he wants to sell a
covered call. Dave bought the stock at $14.00/share. By selling the "May 15 covered call"
Dave has agreed to sell his XYZ Stock in May for $15.00/share. As long as Dave paid less
than $15/share, he will make a profit. On top of his profit, Dave keeps the money he received
from selling the covered call. In this case, Dave receives $75 (or $0.75/share) from selling
the covered call. Dave's profit is $175 -- $100 from selling the stock and $75 from selling
the covered call.
Sounds wonderful, doesn't it? There is a downside. If XYZ stock shoots up in price Dave
still must sell his stock for $15.00/share. If the stock price surges to $25/share, Dave's
selling price remains $15.00/share. While Dave doesn't lose money and actually realizes a
profit, he does miss out on the upward movement in the stock price above $15/share. This
could be quite frustrating if XYZ stock climbs significantly higher than $15. By
writing the covered call Dave is selling the upside potential of the stock to speculators.
What if the stock price goes down instead of up?
 Once again the outcome is similar to
owning stock. If Dave hadn't sold the covered call, he would start losing money on the position
if XYZ stock fell below his original cost of $14.00/share. However, since Dave did sell the covered
call and he received $0.75/share for it, his cost is lowered to $13.25/share ($14.00/share - $0.75/share).
Now the stock must fall below $13.25/share for Dave to lose money. This is known as his
"cost basis". The premium of $75 ($0.75/share) that Dave receives for selling the call is
often called the "Safety Cushion" because the stock can decline by this amount and still
be a profitable trade.
The important factor to remember is that Dave can lose money if the stock price falls, just
like owning stock without selling covered calls. Because he sold a covered call, he has
reduced his cost basis for the stock, but if the stock falls below his cost basis, the position
is now in a "losing" territory. If Dave were to close the position at this point, he would
realize a loss. Dave knows that it is often better to close out losing positions instead of waiting and
hoping that they will recover, so he monitors each position to control his losses.
We've covered what happens if the stock price goes up or if the price goes down, but
what happens if the stock price doesn't move much in either direction? In our example,
Dave sold the May $15 covered call. As long as the price of the stock is below the strike
price on the may expiration date then the covered call that Dave sold expires worthless.
When this happens Dave keeps both his stock and the premium that he received from the
covered call. His covered call position is now closed and Dave can sell another
covered call the next expiration month.
THE MOST IMPORTANT STEP
WHEN SELLING A COVERED CALL
THE MOST IMPORTANT STEP: By far the most important step when selling a covered call is
selecting the right underlying stock. As long as the stock price does not fall, the
covered call will close at a profit. Thus, researching and buying an underlying stock
that will not decline should be the objective of all covered call traders.
While it is the price of the stock that determines if the position closes at a profit
or a loss, it is the price of the covered call that determines the size of the potential
profit. This factor leads many covered call traders to buy stocks that have high
option premiums without regard to the stocks' underlying fundamentals. Before opening a
covered call trade, investors should want to own the underlying stock. If the underlying
stock is not a good investment in itself, then it is also not a good covered call candidate.
With the covered call strategy, an aggressive investor may target a higher return by selling
covered calls on volatile stocks. In each case, however, the investor should feel that the
stock price will go up. The underlying stock is the foundation of the trade. Selecting a
poor foundation because the potential profit is high is asking for trouble.
FOUR COMMON MISTAKES THAT ARE MADE
WHEN SELLING COVERED CALLS
 Dave knows that he is going to occasionally have a few losing trades.
While his "number one" objective is always to make a profit, his second objective is simple. "Don't
fall on his face!" Below are 4 common trading mistakes that
investors make when selling covered calls.
MISTAKE #1: Too Big of Trades - The easiest way to fall flat on your
face when investing is to allocate too much money into individual positions.
Small losses can be easily recovered by a couple profitable trades, but large
losses can leave investors without the funds to continue trading.
MISTAKE #2: Buying Back The Call When The Stock Price Goes Up - Anyone who regularly
sells covered calls knows how frustrating it is to have the stock rally significantly above
your strike price. Why is this so frustrating? Because the investor would have made a lot
more money if he or she hadn't sold the covered call. When a stock does rally above the
strike price, the first reflex of investors is to buy back the covered call so they can
keep the stock. Very rarely is this a good idea.
When a stock rallies, the price of its calls shoot up and factor in a higher premium for
the stock's movement. If the investor then buys back the covered call to close the position,
he or she will often pay the top dollar for the call just to watch the stock pull back at his or her expense.
If the investor times the buyback wrong, it is likely that he or she will lose money on a
position that was practically guaranteed to close at a profit.
MISTAKE #3: Choosing A Stock Because It Has High Covered Call Premiums - It is easy
for covered call investors to be blinded by the potential profit of a covered call trade.
These potential returns can easily reach 10% - 25% in one month. The key word is "potential"
returns. If the stock price drops these returns quickly evaporate and losses start accruing. Choose
your stock first, then select the option. Yes, we know. We have a list of high premium
covered calls on our site. Just because a covered call has a high premiums does not mean that it
is a bad trade, however, it is a bad trading practice to choose to enter a position solely based on the
potential return.
MISTAKE #4: Failing to Exit Losing Positions - Just like investing in stocks, it is
important to cut your losses when selling covered calls. It is easy to close a covered
call trade. First you buy back the call that you sold (it will usually be cheaper if the
stock price has fallen). Then, sell the underlying stock that you own. While closing the
trade requires paying commissions on two transactions, it is often far less costly than
holding the losing trade and watching it get worse day by day.
Selecting quality stocks and avoiding these three common mistakes will give you a
trading edge and drastically improve your covered call performance.
A COVERED CALL EXAMPLE
Let's imagine that you've owned Diamond Dave's stock for years. After multiple stock splits,
you now have 1,000 shares. Pleased with the overall growth rate, you decide to hold the stock
rather than sell it. Rather than just sitting back in a traditional buy and hold position, you
decide to use options to generate some additional income (cash flow) at very little risk to you.
For example, with the stock at $31 you could sell ten $35 calls for the current month at $1.
When you sell the covered calls, $1,000 ($1.00/share x 1,000 shares) is immediately placed into
your brokerage account.
Knowing the stock price hasn't fluctuated much; you might have confidence that it isn't going
to move higher than $35 in the before expiration. After all, that would be a more than 10% move.
At expiration, if the stock is still below $35, you keep the $1,000 you received by selling the
calls, as well as your stock. At that point, you might decide to write (sell) a few more calls
for the next month.
Should the stock rise unexpectedly above $35, and stay above $35 on expiration, your stock will
be called away and sell your 1,000 shares (10 contracts x 100 shares) at the strike price of $35.
CONCLUSION
Now you know just enough about covered calls to be dangerous! While we have just briefly
explained the covered call strategy, you should now have an idea
if this type of strategy fits your investment profile. If you are interested in learning
more about covered calls, we invite you to explore this strategy further. There are books
that explain covered calls in greater detail and many
Option Advisor Services that will
be happy to help you get started.
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Notice: Options like most investments involve risks and are not suitable for everyone.
Prior to buying or selling options, an investor must receive a copy
of Characteristics and Risks of Standardized Options. Copies may be obtained from your broker or from the
Exchange at LaSalle at Van Buren, Chicago, IL 60605.
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