WRITING COVERED CALLS  A CONSERVATIVE OPTIONS STRATEGY


May 8, 2000







No doubt you've heard lots of commercials where salesmen frantically pitch the incredible earnings potential buying and selling stock options. While that’s literally true, it only happens for a tiny fraction of the people who trade options; most people lose money doing it. The simple facts are that options are generally very risky financial tools to use, and they are not for the faint-hearted. Can you make money trading options? Yes, it's possible, if you adopt a very conservative strategy. Besides being able to make some, though not huge amounts of money, you'll have much less paperwork to deal with when you prepare your tax returns, compared to the more aggressive strategies with options. You'll also sleep better with a conservative strategy. Simply put, writing covered calls is one of the safest strategies for using options, with the best chance of consistently making a profit.

First, an explanation of the terms. An option is simply the right to make a particular kind of financial transaction; a call is a certain kind of option that gives the purchaser (of the option) the right to purchase a certain security, like a stock, at a certain price. For example, you can purchase a call on Proctor & Gamble stock that allows you to buy the stock at a price of $70 per share. You have the right to purchase the stock at $70 per share as long as the option lasts. Why do they call a “call” (the option) by that name? Literally, it means anyone who has purchased, or owns, a call, has the right to “call” (take) it away from someone else who owns it, for a purchase price of $70 per share. Of course, where there is a buyer for the call, there must also be a seller; that's you in this case. (More about that soon.) I've also just hinted that a call (like other kinds of options) has a finite life span. Assuming you are talking about how long a span of time a call has from the day it is created (when they become available on the market), their life span can be from about a month to several years. All other things being equal, the longer the length of time they are good for, the more they cost. On the flip side, if you're the seller, then the longer the term of the option you sell, the more you’ll get for it. Note this; if keep an option until its life span runs out, then it has “expired”. It is now worth nothing. Whatever you paid for it is a tax-deductible loss, so that cushions some of the blow.

You still need to know a few more terms before I discuss the actual writing of covered calls. Writing a call (see the end of the first paragraph) is another expression for selling a call. If you write (sell) calls, then you must also be prepared to deliver (sell) stock to someone at the price the option you wrote specifies (in our previous example, $70 per share). If you write calls against stock you already own, then you are writing covered calls, meaning in case the purchaser of your option uses, or exercises it, to buy your stock at $70 per share, you'll have the stock to sell. While you can write calls against stock you don't have, that's an extremely risky transaction; only the most fearless (or stupid) of traders do it, and it's called writing uncovered calls. In that case, you'll have to find a way to buy the stock quickly you don't already have, and then sell it to the person who bought your call.

To make money selling calls, you want to strike the best balance between getting the maximum amount of money for the calls you sell, while having the least chance of having to sell your stock at the price specified by the option you wrote. Ideally, you want the option you sold, and collected money for, to expire worthless in the hands of the purchaser. How is that arranged? The calls you sell against your stock specify a purchase, or strike price, that is currently above what the stock is selling for on the market. Going back to our example of Proctor & Gamble, you sell a call specifying a strike (purchase) price of $70 per share, while the stock is currently selling for $55 per share. You are assuming the price of Proctor & Gamble will not rise above $70 per share before the option expires, meaning the person who bought the option will not have a chance to use it before expiration.

If that happens, what's the result? You keep you shares of Proctor & Gamble, and you keep the money you collected for selling the call to someone. What next? After expiration, you can write another call, collect more money, and wait to see what the market does to the price of Proctor & Gamble. As a general rule of thumb, the closer the strike price of the option is to the current price of the stock, the more money you'll get selling the option; the further away the strike price is from the selling price, the less money you'll get. Why, you may ask, would anyone purchase the right (option) to buy something for a price that's higher than what it now sells for? Because they think there's some chance the selling price of the stock will go up so much in the near future, that buying it at the price specified by the option will be a bargain. Our previous example is good for one more round. If Proctor & Gamble was selling at $55 per share when you sold your option to buy it at $70 per share, that option would be useful to get the stock at $70 per share, if it rose to $90 per share before the option expired. Thus, you as the seller hope the stock price doesn't rise, while the purchaser of your option hopes the stock price does rise.

What happens if the purchaser of the option exercises (uses) it to purchase your stock? You sell it to the purchaser at the previously agreed upon price; in our example, $70 per share. You still get to keep the money for selling the call. If you did things as per our example, then you'll also make money selling the stock at $70 per share; it was selling for $55 per share when you sold the option, and you sold it at $70 per share when the person who bought your option used it. If things were that easy, then you’d have it made; just a few simple transactions every few months for significant, additional income. What really happens, though, is usually something more complicated. You sell your option, specifying a strike price above the price of what your stock is currently selling for. As time passes, the selling price of your stock goes up, over the strike price of the option you sold. Now what? If the selling price of your stock stays above the strike price, there is at least some chance the person who bought the option will use it, to buy the stock from you cheaper than what it is selling for on the open market. You can buy the option back that you earlier sold. Chances are that despite the stock's increase in price, you can buy the option for less than what you sold it for, still making a profit. Then you can sell another option, with a higher strike price, than the first one, and collect more money.

It's also good to mention that writing covered calls is a good way to neutralize some the loss in value that all stocks experience at one time or other. If you've ever been frustrated by the feeling of watching your stocks steadily decrease in value, wondering if you should sell at a loss, then consider writing covered calls. When the price of the stock decreases, you'll never have to worry about the purchaser of your call using it to buy your stock. Also, the money you collect for writing the calls will partially offset the decrease in value of your stock; hopefully, you'll then come out ahead in the long run when the share price rises again.

By all means talk to a financial adviser before trading options; my article is an opinion, and not official financial advice. Certainly don't trade options if you've had no market trading experience of any kind. Even if you have a brokerage account, you'll have to meet some additional requirements before they'll let you trade options, including having a certain number of years trading experience, a minimum account value, and other qualifications. Options trading also demands meticulous record keeping for income tax filing, and it will almost certainly make filing your tax forms more expensive. If anything, start out small, and before even worrying about whether or not you'll make a profit, just determine if the risk of covered call writing is for you.




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