Are Covered Calls for You?

 

by Dennis Borgeson, The Option Yield Report

Covered Call Safety

"Writing Covered Calls is not only the safest of all option strategies, it is also safer than purchasing and selling stocks only.", Chicago Board Options Exchange.

Writing covered calls reduces your stock investing risk because the option premium received lowers the cost.  "Writing covered calls is actually more conservative than simply owning the stock," says Kevin Murphy, options strategist at Salomon Smith Barney. Writing covered calls is profitable, easy to do, and so safe the U.S. government has approved writing covered calls in an IRA.

The leading stock mutual funds yield around 20% per year; imagine making 5 to 25% per month writing covered calls with less risk.  The details, of writing covered calls, are handled by your broker; you place the orders and collect the premiums.  Cash from covered calls can then be used to provide a comfortable living, or compound into great wealth.

Covered Calls vs. Naked Calls

Ever hear options are high risk investments?  There are two kinds of options -- naked and covered. 

Naked options are very risky because the seller of the option doesn't have sufficient shares to deliver if the option is exercised.  Being short (naked) the underlying stock, the option seller must buy shares, perhaps at a very high price, then sell them to the option buyer at the contract strike price.  Not so with covered options.  Since the option seller already owns the underlying stock, they can deliver shares from their account.

Retirement

You can experience accelerated capital growth when writing covered calls.  Gains on covered calls compound monthly.  By writing covered calls in a self-directed IRA at 10% gain per month, $978 could grow to $2,933,083 in seven years.  Writing covered calls in an IRA allows you to make up for those years you didn't save enough for retirement.  In general, your retirement funds will come from four sources:

  • Pension Plans

  • Social Security

  • Tax-deferred savings

  • Basic (taxable) savings

Add the income from these, then determine how much you need to make writing covered calls to provide the balance.

What are Covered Calls?

Call options give the option buyer the right to buy stock (from the option seller) at the strike price.  Put options give the option buyer the right to sell stock (to the option seller).  Call options are covered calls when you own the stock the covered calls are written against.

Stock options are traded each business day in units of 100 shares; fractions of a unit can't be traded.  Writing covered calls gives someone the right to buy stock you own, at the option strike price.  You can also buy stock with the intent of writing covered calls as soon as your buy is confirmed.  This strategy is known as buy-write.

Even though you have sold covered calls, you still own the stock until it's called.   If it pays a dividend you benefit.  If it takes a dive, you could lose money.  Make sure to research the stock underlying the covered calls thoroughly.

When writing covered calls, the option premium from the sale is deposited into your account the next business day.  It is yours regardless of what the stocks or covered calls do in the future.

By writing covered calls, you are selling the upside potential of stock to speculators.   Since your focus is on monthly income not long-term capital gain when writing covered calls, it is advantageous if the stock price goes up and the stock gets called away.

When writing covered calls you must do one of the following:

    Allow your stock to be sold at the option strike price anytime before the covered calls expire.

    Buy the covered calls back on the open market before they are exercised.

    Let the covered calls expire unexercised (on the third Friday of the month).

    For instance, if you purchase 100 shares of stock for $4.75 per share, you could write $5.00 covered calls.  Let's say the option premium is $0.50.  The premium yield would be $0.50 divided by $4.75, which is 10½% in 36 days or less, on the covered call option premium alone.

If you sell covered calls and the stock does close above $5.00 on the option expiration date, your stock will be called for $5.00.  This would produce a capital gain of $0.25 on the sale of your stock in addition to the $0.50 per share covered call option premium already received.

Otherwise, if the stock does not close above $5.00 on the option expiration date, the stock will probably not be called.  You could then write covered calls again for the next month using the same stock to cover the covered calls.

To Write Covered Calls

1)Have your broker buy the stock you've selected for covered calls in increments of 100 shares.

2)Then, have him sell the covered calls.  If you don't want the stock to be called, you could roll up or roll forward.  You could keep writing covered calls and collecting option premiums each month until called.

 

All contents ©2004 Life Security, Corp.  You may not copy or paraphrase any part of this publication without express permission from the publisher.

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