by Dan Keen

Stacking the Odds in Your Favor

Options trading can be risky. However, writing covered calls is one option strategy that actually makes stock market investing a little less risky, and it should be part of the novice’s bag of strategies. 

Of course, there are no guarantees, but writing covered calls stacks the odds for a successful trade in your favor. You have a two-out-of-three chance of making a profit. A stock price can go up, down, or stay at the price you bought it. When you write a covered call option on a stock, you make money if the underlying stock price goes up and you make money if the stock goes sideways. Even if the stock goes down, the money you received from selling the option offsets the drop in stock price. You will still own the stock, in which case you can wait and hope it will eventually recover.

You’re not expected to comprehend all of the details of this income producing strategy right away. It is recommended you get started by doing paper trades (pretending to buy a stock and sell a covered call). Get good at this phenomenal way to make extra income before you risk any real money. Hands on experience is the best teacher, and after a few months of simulated trading you should feel comfortable enough to try the real thing.

The Game Plan

First, we will identify a stock that we are neutral to slightly bullish on in the near future, that is, whose price we believe will either remain about the same or increase slightly over the next moth or two. Next, the stock must be one that is “optionable” – one that is listed on an options exchange. It must also be a stock that we can afford to buy at least 100 shares of, because option contracts are written in 100 share increments. Finally, we must look at the current list of option prices for the stock, determine a “strike price” and an “expiration date” – a price we are willing to sell the stock for and a date to terminate the offer, then decide if the “premium” we would pay is worth the risk of the play.

Let’s go through the procedure of doing a hypothetical covered call play to give you a basic idea of the plan. Let’s say you read in a financial newspaper that XYZ Computer Company predicts strong sales this year. Using your computer and internet you check out the company by going to a site that offers stock research, (such as MarketWatch or Zacks). You enter the ticker symbol and see the company’s stock price is currently at $23. You pull up a chart on it, and see that the stock has been slowly, but steadily rising over the past few months. The average daily volume is one million shares, so it has a lot of liquidity. You continue to look at other characteristics of the company, such as its 52-week high and low price, and the number of institutions which has stock in it. You read all of the recent news you can find on it.

Is the stock optionable?… You check the Chicago Board Options Exchange website, under quotes and data, you check “delayed quotes” and enter ticker symbol “XYZ” and a chart appears.

You have $2,500 in your brokerage account, so you have the funds to buy 100 shares of the stock. The next higher strike price above the current $23 stock price is $25. Strike prices (prices that options are written at) begin at $5 and increase in increments of $2.50 until you reach higher prices, where they jump in $5 increments. It’s January 1st and the next option expiration date is the third Friday of the month (options always expire on the third Friday of each month). You scroll down the list to JAN 25 and look horizontally to the BID column: $1.50 is shown. This is the premium (the money) you would receive if you wrote a covered call for January with a $25 strike price. Is this a good deal?

Commission fees must be considered to ensure the play would be profitable. Assume you are using an online broker that charges $8 to buy a stock and $15 for an option transaction. Buying 100 shares of the stock will cost $2,300 plus $8 commission, or $2,308. To write a covered call for January 25, you would receive $150 (which is $1.50 times 100 shares), less $15 commission, for a total of $135.

Is this a good return on your investment? You spent $2,308 and received $135. Your obligation to hold the stock will last three weeks. To calculate percent return, divide the profit by the cost, then multiply by 100 to express in percent, (135 / 2,308) x 100 = 5.8% return. Remember, that’s 5.8% in three weeks, not one year. We are used to thinking about a return on investments in annualized terms, but now we have generated $135 from a $2,308 investment in only three weeks. That looks like a good play! And, if the stock goes up beyond $25, someone may take you up on your offer and buy the stock from you (exercise the option). In that case, you will receive $2,500. You paid $2,308, so that’s another $192. Add that to the $135 you were paid for writing the covered call, and you made $327, which is a 14% return on your money in three weeks!