Options Trading: Covered Calls

by FinancialTips4U

Most basic option available

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell a stock at a specific price on or before a certain date.  That date occurs monthly, and it is generally the Saturday after the third Friday of each month (unless a holiday intervenes). A normal options contract consists of 100 share quantities.   The most basic option is the covered call.  Here's how it works. 

Say you purchased 100 shares of DIRECTV (NYSE: DTV)  at $36.00 a share and you like its long-term prospects, but feel the stock will trade flat in the near term, close to its current price of $36. If you sell one October 36 call option on DTV for $0.90, you would earn $0.90 per share in exchange for giving another trader the right, but not the obligation, to buy those 100 shares from you at $36, on or before the third Friday in October ("options expiration").  Since it is $0.90 per share, and you own 100 shares, you would earn $90 for giving him that right.  One of three scenarios is going to occur:

a)

DTV shares close at the $36 strike price on October options expiration.  You keep the shares you own and the $90 (called "the premium").  You just made a 2.5% return on the deal. 

b)

DTV shares close under $36.  Again, you keep the shares and the $90.  If the stock closes at or above $35.10 that day, your $90 premium is offset by an unrealized loss.  But since you haven't sold the stock, that loss isn't real until you actually sell the stock at some later date.  Suppose the stock closed at $34. Although you lost $2.00 per share on the stock, you collected $0.90 per share, giving you a net loss of only $1.10 per share.  Hence, you created a successful hedge for that month. 

c)

DTV shares rise above $36.  The trader will certainly exercise his option to buy those shares at $36 because now they are worth more than that!  Say the stock closes at $38.  You may be sad to have missed out on that $2.00 per share gain, but at least you picked up $0.90 per share when you sold the covered call.  So you missed out on $1.10 upside. 

Steps to Action

Guidelines for choosing which stocks to own and sell calls against.

Choose a stock with trading patterns.

Look at a multiyear chart.  I do my research using the Firstrade options trading tools but any good stock information site should have these resources. Has the stock been range-bound for awhile?  Has it been dead money recently?  That's a good candidate. Stock volatility is what makes option premiums larger, but that also means less certainty about where the stock will end on expiration. 

I recommend:  If a stock I wanted to own anyway drops after I sell a call, the gain from selling the call option is a nice hedge, and I might buy more -- unless the stock's fall is due to some kind of un-looked-for news that changes my mind about wanting to own it.

Choose equities that remain constant regardless of news

You want to choose a quiet stock that doesn’t have a history of big moves.

I recommend: Scheduling options calls between quarterly earnings reports. This avoids having the stock option be called due to a surprise report of positive earnings.

Tips & Tactics

Useful advice about how much to sell and at what price.
  • Write (sell) covered calls against only portions of your entire holdings.  You are hoping your equity position rises over the long haul.  Thus, if you're writing calls, you are doing so because you believe the stock will either go down or stay flat.  Likewise, if the stock should rise significantly, you don't want to get sold out of your position in its entirety.
  • Minimize your trading costs by writing calls in large chunks.  Decide on a return you want from each trade, such as 2% monthly.

Updated: 10/28/2011, FinancialTips4U
 
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