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Beat The Market By Using Call Covered Traded Options Strategies - Part 1

InvestorEducation / Options & Warrants Nov 29, 2007 - 09:12 AM GMT

By: Hans_Wagner

InvestorEducation Best Financial Markets Analysis ArticleInvestors who wish to beat the market using a conservative approach might want to consider using covered call option strategies to enhance their overall return. Writing covered calls helps to improve the total return of an investor's portfolio if they apply several important principles. Covered calls are approved for use in Individual Retirement Accounts as they are considered a conservative way to use options by the authorities. This is part one of a multi-part series on using options to enhance the performance of your portfolio performance. If you are interested in learning more about options Options Made Easy: Your Guide to Profitable Trading (2nd Edition) by Guy Cohen is an easy read that will help investors understand options.


Definition

A call option is a financial contract between two parties, a buyer and a seller of the of the option and it is normally called a "call". The buyer of the option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying instrument) from the seller of the option by a certain time (the expiration date) for a certain price (the strike price). The seller (or "writer") is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) to the seller for this right. Investopedia has more information on call options if you are interested.

Writing a covered call is a strategy where an investor sells a call option while they own the necessary number of shares of the underlying stock. One of the objectives of a writer of a covered call is to reduce the risk of a small decline in the price of the underlying stock. The writer of a covered call also seeks to increase the overall performance from owning the stock by collecting option premiums that are received from the buyer of the option.

Generally, the writer of a call option is expecting the price of the underlying stock to rise no further than the strike price by the time the option expires, so they retain the appreciated value of the stock, any dividends that have been paid and the premium they received from selling the covered call option. However, if the price of the stock makes a strong upward move, then the covered call option writer will not fully participate in the gain from the stock.

If an investor uses the correct covered call strategy they can improve the total return of their portfolio and reduce the volatility they usually experience. If done properly, an investor can increase the performance of their portfolio 5 to 10% per year, depending on the option strategy they chose.

Profit and Loss Potential

When using a covered call writing strategy it is important for the investor to quantify the potential profit and break-even point of the transaction. Fortunately, there is a simple formula to calculate these performance factors.

· Downside break-even point = Stock price – call price

· Max profit potential = Strike price – stock price + call price

The best way to illustrate this point is with an example. Assume company ABC was selling at 24.00 when you decided to consider writing a December 25 covered call. The bid on the call was 1.50. The table below describes details necessary to determine the max profit potential and downside break-even point for covered call option. 

There are several observations that should be noted. First, the down side protection is $1.50 per share, the premium received from the option. This makes the stock price downside break-even point 22.50, protecting your stock position to this level. Second, the maximum profit potential for this position during its life is $250, $150 from the option premium and $100 from appreciation of the stock to 25.00 or higher. Third, any appreciation in the stock above the sum of the premium from the covered call plus the price of the shares when the call was sold is lost as the value of the call rises above the premium you received after that point. 

The ABC December 25 Covered Call

ABC Price at Expiration
Stock Profit
December 30 Call at Expiration
Call Profit
Total Profit
20.00
$ (400)
0.00
$ 150 
$ (250)
22.50
$ (150)
0.00
$ 150 
$ - 
24.00
$ - 
0.00
$ 150 
$ 150 
25.00
$ 100 
0.00
$ 150 
$ 250 
27.50
$ 350 
2.50
$ (100)
$ 250 
30.00
$ 600 
5.00
$ (350)
$ 250 

The chart below graphically presents the analysis of the ABC December 25 Covered Call write. Notice the shape of the Total Profit curve. This will always be the shape of a covered call write. Also notice that the maximum profit always occurs at all stock prices equal to or greater than the strike price, as long as the position is held until it expires.

As the option gets closer to expiration and the price of the stock of ABC rises to and above the strike price, you are faced with some alternatives. First, you could do nothing in which case the covered call will likely be assigned at expiration and your stock would be “called away” at the strike price. You would retain all the price appreciation in the stock from the price you acquired the stock to the strike price and you also keep the premium you received when you sold the covered call. However, you will no longer own the stock.

The other alternative you have is to buy back the covered call at the current price. If the shares of ABC are trading at 27.50 then the price of the option will be at least 2.50 plus any remaining time premium. In this case you will incur a loss by buying back the option, but you will keep your stock that has appreciated to 27.50. Your profit remains at $250, however, since you still own the stock you can participate in any further appreciation in the price of the shares. You also will experience any decline in the price of the shares as well. The downside protection from writing a covered call is limited to the cash received from writing the option minus the value of the company's stock. 

The third alternative is to hold the option until it expires if the price of the shares remains below the strike price. In this case your profit will be the option premium received and any appreciation in the price of the stock up to the strike price. If the option expires you keep the option premium and the shares of the underlying security. If the shares decline in price you can still hold the option until expiration as the premium helps to offset the price decline.

Basically, the strategy of owning stock and writing covered calls is to outperform the ownership of stock alone. This works as long as the price of the stock rises a little, remains the same or falls slightly. Also, by consistently writing covered calls your portfolio will show less volatility than just holding the stock alone.

In the Money or Out of the Money

Looking at a listing of call options, you will notice that there are two categories listed, in-the-money and out-of-the-money. A call option is termed in-the-money when the strike price is below the market price of the underlying asset. When the strike price of a call option is above the underlying market price of the asset it is termed out-of-the-money. Most of the time using this term only applies when you are first writing the covered call option.

Generally speaking, the in-the-money covered call write offers the investor more downside coverage, while the out-of-the-money covered call option offers higher potential profit with less down side risk protection. 

The table below depicts the profitability of writing an in-the-money and an out-of-the-money covered call for a stock that is selling at 22.50 with the December 20 call selling for 4 and the December 25 call selling for 1. Notice that the in-the-money write has downside protection to 18.5, while the out-of-the-money write downside protection only goes to 22.00. On the other hand the upside on the in-the-money write is limited to $150, while the out-of-the-money write is $300. Basically, the out-of-the-money profit potential of a covered write is greater than what you would receive from an in-the-money covered write. The maximum profit potential of an out-of-the-money covered write always requires the underlying stock price to rise. 

Comparison of In-the-Money and out-of-the-Money Covered Call Options
In-the-Money Write of December 20 Out-of-the-Money Write December 25
Stock at Expiration Total Profit Stock at Expiration Total Profit
17.50
$ (100)
17.50
$ (450)
18.50
$ - 
20.00
$ (200)
20.00
$ 150 
22.00
$ - 
22.50
$ 150 
22.50
$ 50 
25.00
$ 150 
25.00
$ 300 
30.00
$ 150 
30.00
$ 300 

When considering writing a covered call your view of the underlying stock should be to go up over time, remain at the same level or possibly decline slightly. If you believe the price of the stock will decline more significantly, then you should either consider selling the stock or employ other more appropriate option strategies such as buying a protective put. I will explore protectivestrategies in another Point of Interest article at a later date.

The Bottom Line

If you are looking to improve the return on your portfolio then you might consider writing covered calls on the stocks in your portfolio. It is important to understand the potential profit that the covered call offers to you before making a decision. Options with different strike prices including those that are in-the-money and those that are out-of-the-money will offer different profit potential and downside protection. Understand these factors are the first steps to analyze what covered call option to use to help improve the overall return of your portfolio.

In the next Point of Interest, we will explore the idea of a total return that considers the stock as well as the option and the risks that are inherent in using covered calls. We will also explore the return on investment from writing covered calls and the factors to consider in selecting the underlying stock for covered call writing. 

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

Hans Wagner Archive

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