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Thomas Bulkowski’s successful investment activities allowed him to retire at age 36. He is an internationally known author and trader with 30+ years of stock market experience and widely regarded as a leading expert on chart patterns. He may be reached at

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This article discusses the ins and outs of covered calls, prompted by an article in Active Trader magazine by Casey Platt, titled, "Earning dividends with covered calls." You can use covered calls to increase your return, but it also means a commitment to selling your stock.

 

Covered Calls: Background

If you trade stocks long enough and read financial magazines or books, then you will probably come across options, specifically covered call options. A call option gives the buyer of the option the right, but not the obligation, to buy the stock at a fixed price for a limited time.

For example, if you think IBM is going to go up in price, you might want to buy a call option instead of the stock. The option is cheaper than owning the stock and if you're right, the option's price can shoot up. If you're wrong or if the move doesn't occur by the time the option expires, you'll lose the money you paid for the option. You can always sell the option and get part of that money back before expiration, of course.

A covered call means that you own the stock. When you write a covered call, you are selling someone the option to buy your stock at a fixed price for a fixed time and collecting what's called a premium for doing so.

Let's say that you own 100 shares of IBM, bought on the close of October 23, 2009 at a price of 120.36. The November 120 calls sell for $2.70 each. If you sell one contract, you will make 100 shares x 2.70 or $270. The option will expire November 21st at an exercise price of 120. If the stock is above 120, then you risk the stock being called away from you, meaning you will be forced to sell it for $120 per share, regardless of how high the stock is then trading. If the stock's price is below $120, you will make money providing it doesn't drop below your break even point, which is 120.36 - 2.70 or 117.66, and you get to keep the stock and do the same thing all over again.

If the stock drops below break even, then you will lose money, tempered by the premium you earned by selling the call (in other words, the pain is lessened by $2.70 a share, but it's still a loss).

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Covered Call Scenarios

Here are some scenarios.

  • Assume you own 100 shares of IBM stock at 120.36 per share as of October 23, 2009.
  • Assume you write one November 120 covered call option and receive 2.70 per share, including commissions.
  • The option will expire on November 21, 2009.
    • If the stock is $200 per share a expiration, you will sell it at 120 and the other buy will make a bundle. In fact, if the stock is above 120, it will be called away from you at $120. You'll have to pay commissions on the sale of the stock when it gets called away, too.
    • If the stock is at 90 at expiration, you will lose 120.36 - (90 + 2.70) or 27.66 per share. Anything less than 120.36 - 2.70 or 117.66 means you lose money.
    • If the stock is above 120 but below 120.36 + 2.70 = 123.06, then you make money. The stock will be called away and you'll have to pay commissions, but the option premium of 2.70 gives you a cushion.

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Covered Call Recommendations

Here is what Platt recommends. My comments are in parentheses.

  • (Be willing to sell the stock in case it gets called away from you. This is a big one. If you are hoping for long term gains then do NOT write a covered call. Let it go long term first and then play with the option.)
  • The stock's price should be at least $25, preferably over $40 to make the dollar value worth trading. (The fewer option contracts you write the better since commissions are often based on the number of contracts written. Thus, it will be less expensive to write 1 call on a $10 stock than 2 calls on a $5 stock, all else being equal).
  • Calls should be valued at $2.50 or higher. (Higher is better but I'll settle for lower if it means less risk of my stock being called away).
  • Select at the money calls (or very near the current price) because they have more extrinsic value. (I prefer option prices above the current price. That way, it has less chance of being called away and you get to keep both the stock and the premium. But the premium will be lower...)
  • Pick popular stocks with good earnings growth and high betas. He says these have done well in 2009: APPL, AMZN, GOOG, RIMM, POT, MOS and MON. Of course, you need to own these stocks before you write the call... (Look for stocks with unusually high volatility when you write the call -- boosting the premium -- but you expect may calm down by expiration day).
  • Stocks should have daily volume of at least 5 million shares. (I don't think this matters at all and it sounds much too high anyway. What's important is the option's open interest)
  • Option volume should be 100,000 contracts. (I would look for a strike price with lots of open interest, and activity so you can enter and exit easily without being killed on the spread.)
  • Look for a bid/ask spread of 10 cents or less.
  • Pick options that expire in 20 to 40 days.
  • Split the bid/ask spread into two and place a limit order at that price. If the bid is $1 and ask is $1.10, then place a limit at $1.05.
  • Avoid owning covered calls in the two weeks surrounding earnings announcements. Volatility is highest then.
  • Avoid stocks in which the prior quarterly report included an earnings warning. You want strong companies. (But if you own the stock, then write a covered call at or in the money and collect the premium if you expect the stock might suffer during this quarter. You get to keep the stock and high premium that way. If the stock does tumble, it won't be quite as painful).
  • Avoid stocks that have rallied. Enter only when the stock has dropped recently. That increases implied volatility. (I look for the stock to move in a trading range because I want to continue owning it. His suggestion makes it more likely the stock will go up and be called away).
  • (Yahoo!Finance has an options calculator called "Options Analysis Tool" that gives the probability of success. Check that before trading).

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Covered Call Example

Platt gives this example for Research in Motion, RIMM.

DescriptionEntry July 10Exit July 16
Buy 100 Shares-$6,595$7,192
Sell August 65 call+$500-$817
Total:-$6,095$6,372 or $280 profit

Assume you buy the stock on July 10 at a price of $65.95 (which is a cute trick since the low for that day was 66.10, according to yahoo!finance, but I'm just being a pest) and sell a call option for $5 per share, or $500, covering those 100 shares. That effectively lowers your purchase price to $60.95.

Six days later, the stock has moved up to 71.92 and you decide to sell it. However, the call option is in the money so buying back the option will cost you $8.17 per share or $817 for 100 shares. Even so, that means you make $280 in six days. He writes, "...Too many people focus on an option position's possible gains at expiration. Waiting until then doesn't always make sense, especially if the underlying climbs sharply and allows you to capture most of the position's potential gains within just a few days." In the RIMM example, the $280 profit is 70% of the potential $405 gain ($500 premium - $95 in the money at purchase time).

What he doesn't tell you is that just buying the stock at $65.95 and selling it at $71.92 would have made more money: $597, or more than double what he made using options. Oops.

Holding the option to expiration would not have been a good idea either. The stock closed on Friday August 21 (the day before expiration) at 77.32. The stock would have been called away at 65, so you would have missed out on $637 (77.32 sell price - 65.95 stock cost + 5.00 premium).

Covered Call Summary

As I mentioned in the recommendations, I write covered calls on stocks I expect to move sideways. You can make a good return by selling covered calls but your turnover will increase and you will miss some of the upside, especially in this bull market.

-- Thomas Bulkowski

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Written by and copyright © 2005-2017 by Thomas N. Bulkowski. All rights reserved. Disclaimer: You alone are responsible for your investment decisions. See Privacy/Disclaimer for more information. If you knew what you were doing, you'd probably be bored.