Let's talk Covered Calls

Well I realized I've been mouthing off about the Portfolio 24 and the wonders of covered calls -- and haven't really explained what they ARE to newcomers.

Options experts can tune out for a couple paragraphs here -- with the knowledge that I do admit upfront that selling puts has the same risk/reward profile, and slightly less commissions. But -- keep in mind that most people reading this probably don't have the upfront capital or time or specialized charting techniques to find good put possibilities.

Let's get the basics out of the way.
There are two kinds of option contracts -- calls and puts.
Buying a call allows you the right to buy a stock at a certain price, by a certain date. Selling a call obliges you sell that stock to the call buyer at that certain price.
Buying a put allows you the right to sell a stock at a certain price, by a certain date. Finally, selling a put obliges you to buy that stock from the put buyer at that certain price.
Note that buyers have rights while sellers have obligations. Exercising a call means that the option buyer forces the option seller to consummate the deal.
That "certain price" is called the strike price, and the "certain date" is called the exercise date -- the third Friday of the month.
Ordinarily, option contracts are for bundles of 100 shares. But the prices are quoted at a per share basis. So if you see a premium price of $1.00, the contract would actually cost $100 plus whatever commission your brokerage charges.

So -- when you buy a call, you pay a premium for the right to purchase the stock by the exercise date for the strike price. Let's look at a concrete example.
Elan (ticker ELN) closed today at $24.65. The June
2008 exercise date call for a $25.00 strike price (I abbreviate this at the Jun08 $25 - ticker ELNFE) could be bought for $2.20. So if you buy three contracts, you pay $2.20 * 100 * 3 + commission ... at Scottrade this would cost you $670.75.

So you've spent $670 bucks -- let's look at the negative first. If the stock closes below $25 on June 20 (11 trading days from now) then you lose the entire amount. Ouch! (note -- I am not a huge fan of buying calls -- you have to be right in both the timeframe AND the price direction of a stock) The good news is that as Elan goes above $25, your option starts having intrinsic value -- for example if Elan is at $26, then a $25 call would be worth $1 intrinsically, since you could buy the call and then exercise and sell the shares on the market for $26.
So after the shares hit $27.20, you have all profit (you bought the calls for $2.20, so $2.20 + $25 strike price = $27.20. Excluding commisions, of course!) Keep in mind that the longer the option has until the exercise date, the more extrinsic (time) value the option will have, too. Remember, you bought the call when Elan was below $25 -- so all $2.20 was time value. So if the price zoomed tomorrow from $24.65 to $27.20, the option would not only be worth the $2.20
-- it would still have some time value too -- maybe being worth around $3.50 or so. You can also sell the option before the exercise date -- if you buy 3 contracts for $670 and sell them for $3.50 * 100 * 3
(- commission) = $1039.25 then you've made $370 off that $670 in one day! That, my friends, is the lure of options -- they are HIGHLY leveraged.

The exact terminology you use to trade options is very important. When you start your trade, either buying OR selling your call, you buy-to-open, or sell-to-open, respectively. Then when you end your transaction, either selling the call you bought, or buying back the call you sold, you buy-to-close or sell-to-close. If you buy-to-open, and then want to end it, but choose to sell-to-open, then you have two open transactions still!!

Okay, let's go over selling calls, and why I think they are a phenomenal method of generating returns.
Let's stay with Elan.

The Jun08 $25 sells for $1.90 (just like you have to buy a stock at a higher "ask" price than you could sell - "bid" - it for, option contracts generally have a pretty wide spread). Normally, if I were selling the call, I would set a limit trade for a little above the bid price -- maybe $2.00 in this case. You run the risk of not having the trade go through, but you also get a higher price if it goes through -- and usually during a trading day it will fluctuate a fair amount! Let's say this goes through at $1.90 though -- those same 3 contracts will give me an extra $1.90
* 100 * 3 (minus commission) = ~$560. Note -- whether exercised or not, I keep this premium of $560.

Okay -- before going through the rest of the example, I'm going to throw one more term at you. I always do Covered Calls. Remember, if you sell a call, you HAVE to sell the shares to the call buyer at the exercise price, if they choose to exercise it. If you are selling "naked" calls, then imagine this scenario.
You sold 3 $25 Elan calls at $1.90, and the stock skyrockets to $40. The call buyer exercises, and you have to buy 300 shares of Elan at the current $40 per share and then turn around and sell the shares to the call buyer at $25. You LOSE ($40 - 25 + 1.90) * 300 = $5070 (plus whatever commissions you are forced to pay)!!!

A covered call, on the other hand, means that you buy (or previously own) the stock, prior to selling the calls. You are "covered" against having to buy them at market price.

So let's see what happens to me, buying 300 shares at
$24.65 and selling 3 calls at $1.90. First I buy the 300 shares for $7,402 (remember your commission
costs!) and gain $560 premium from selling the 3 calls. 560/7402 = 7.5% return for the next 11 days!
(that translates into an annualized return of 250%, but who's counting? *grin*) And that $560 stays with me no matter what.
If Elan is below $25 on June 20, then I keep not only the $560 but my 300 shares (and probably turn around and sell the July $25 or $30 calls for more premium).
Do note that if the stock tanks to $15, then it is VERY small consolation to still have 300 shares of a
$15 stock that you bought 11 days ago for $25. So there is some risk here. This strategy is meant for stocks that you wouldn't mind holding onto for a while anyways, even it does go down!
Now, if Elan is above $25 on June 20, then my shares will be exercised away from me. The call buyer will force me to sell the 300 shares at $25.00, which means I get credited $7,500 (minus commission) = $7483.00.
That means I spent $7402, made $560, and made $7483 =
$641 for 11 days worth of work. That is 641/7402 = 8.66% return -- just imagine doing that 12 months in a row and you are looking at 100+% returns.

PLEASE DON'T EXPECT 100% RETURNS. Really. That is one example, and to get such high premiums usually means there is quite a bit of risk too. I think you can get 2% a month without undue risk, but nothing is ever certain. Except, err... taxes.

Let's talk about taxes. To avoid very complex reporting requirements, follow these guidelines:
Do not sell calls more than 2 strike prices below what the share price is.
Do not sell for a loss and then buy again -- wash sale rules apply to options too.
If you sell January options less than 60 days before the exercise date, let them expire or buy them back at a gain.

In future posts I will share some ideas, in as real time as I can, for situations that I think are ripe for selling covered calls. And of course, my Portfolio 24 can be tracked as I always post the trades within a day and keep track of commissions within it.

Lastly, if you decide covered calls are for you, please do several “dry runs” first – write down what you think might be a good trade and wait to see if everything happens as you expect. Your real money accounts are NOT a good place to learn!

Regards,
Trond