A Basic Covered Calls Strategy
By Steve Gillman
Let me start by saying that you can lose money with
this covered calls strategy, as you can with any investment strategy.
No promises here, just an interesting technique that investors
have used to make money... and sometimes to lose it. (And I do
not personally use this strategy to make money.)
Options can be confusing, so I'll explain only the basic call
option. It is a contract that gives the holder the right--but
not the obligation--to buy a 100 shares of a stock at a set price
(the "strike price") by a set date, the latter being
the third Friday of whatever month is specified. Let's look at
a specific example. It is December 3, 2010 today, and FirstEnergy
Corporation (FE) stock closed at 35.63 per share. Looking down
the list of the many different options available to buy or sell,
I see this: Jan 37.50 0.35. That means a January call option
with a strike price of $37.50 sells for 35 cents per share, or
$35 per contract (which covers 100 shares). It expires on January
21 (the third Friday). If the price of the stock is higher that
$37.50 by then, it is likely that the option will be exercised,
meaning the holder will buy those shares for $37.50 each, or
$3,750 for the 100 represented by each contract.
Because the strike price is above the current price, this
is called an "out of the money" option. Historically,
most of these expire worthless. That's part of the reason we
might want to be on the selling end. Now, if you just went out
and sold ten of those options without owning the stock, they
would be "naked calls." Your broker might allow this
if you have a lot of money and experience. You would get $350
deposited into your account, minus about $15 in commission. If
the price didn't go above $37.50 in the next six weeks, you made
an easy profit.
This is risky, of course, Suppose the stock goes to $50 by
January, and you have to sell 1,000 shares (10 contracts times
100 shares) at $37.50. You'll have to first buy them at $50,
so you'll lose a total of more than $12,000.
Selling covered calls, by contrast, is less risky. You own
the stock you sell the calls on. So, to return to the example
above, lets say you bought those 1,000 shares of FirstEnergy
Corporation at today's price of 35.63 per share. You like the
future of the company and you like the 6.3% dividend yield. But
you want to make even more with your stock, so you sell ten January
37.50 calls and collect the $335 you get after the commission.
Now if the price rises to $50, you will miss out on most of it,
but because you bought at 35.63, you'll still make about $1,360
when you are forced to sell for $37.50, plus the $335 you already
made. Not bad, and if the price stays about the same, you keep
selling options every month or two when the old ones expire,
perhaps generating an extra 5% annually on top of the dividends,
making over 11% even if the price is the same a year from now.
Now to that Covered Calls Strategy
Okay, the above is an example of one strategy, which is to
sell call option to boost incomes from stocks you own. I used
it to explain the basics of call options. The ones described,
by the way, are what's called "out of the money" calls,
because the strike price is above the current price. Now we're
going to look at buying low-priced stocks and selling "in
the money" calls as a way to lower risk while making short
term gains.
"In the money" means the stock is already higher
than the strike price of the call option. For example, Microsoft
(MSFT) closed at 27.02 today, and among the many options you
could sell is a January 24 at 3.20 ($320 per contract). Why would
you want to do that. You wouldn't, in this case. But there are
times when you can get quite a bit for a call option that is
in the money, and if you just bought that stock you can effectively
lower your price while potentially making a fast profit. Let's
look at very specific examples, again using today's (12/03/10)
real prices.
Orexigen Therapeutics, Inc. (OREX) closed at $4.81 today.
Lets say you bought 1,000 shares at that price, for a total of
$4,815 including a discount broker commission. December 4 calls
have a bid of $1.70, so you sell 10 contracts and get $1,700,
or $1,688 after the commission ($4.95 plus .65 per contract at
my broker). Now lets look at what you've done and what might
happen. Since you immediately recouped $1,688 of your $4,815,
you have only $3,127 at risk. If the stock stays above $4 the
holder of the options will exercise them, paying you $4,000,
so you'll get about $3,950 after the commission. That means you
make $823, having invested only $3,127. Did I mention that these
options expire December 17? Your 26% return is made in two weeks.
Of course the stock could plummet and you could lose most
of your money. This is true of any stock. But remember that it
has to fall a ways before you lose. You just collected $823,
cutting your net cost to $3.99 per share after all commissions.
Now, suppose it did fall to $3.50 per share, so the options expired
worthless. You could hold on, and if it climbs anywhere above
$4 you can sell for a profit. Even though you bought at $4.81
you would be ahead selling at $4.31 thanks to the option money
you collected.
Note: Of course the stock could go to zero, in which
case you lost $3,127--everything.
To reduce your risk and still have the opportunity to make
a return of 5% or more per month, this works best with low-priced
stocks and in-the-money call options. Usually, the companies
whose options have such steep premiums are about to announce
big news, either good or bad, so the stock price is likely to
move quite a bit. If it's a big move down you can lose money.
If it is a big move up you can miss out on most of it since your
stock will be "called away" when the holder of the
options forces you to sell at the lower price.
So the basic covered calls strategy here is to count on the
stock being called away and make your profit on the options.
Otherwise you can dump the stock just after the options expire,
taking your loss, or holding for a bounce back to make a small
gain.
How Much Can You Make?
This is a real example, but an extreme one. There are many
opportunities every month for making 5% in a few weeks, and there
is a site in the resource section below that finds these for
you. There are no guarantees and no way to say what your results
will be--you might even lose everything if you aren't careful
(or even if you are). But assuming you find some of the safer
bets and can average 4% per month on your investments and keep
half of your money invested at any given time, you can make a
total return of 24% annually, which doubles your money every
three years or so. At that rate $40,000 becomes $320,000 in nine
years.
Ways to Make More | Related Opportunities
| Tips
You will sometimes have the opportunity to "capture"
a dividend to make even more money. For example, if you buy the
stock a few days before the ex-dividend date and own it on that
date, you'll get the payout even if you sell the stocks before
the actual pay date. Thus, you might buy a stock, collect for
the call options and the dividend, and so dramatically reduce
your cost of ownership, and so your risk.
Qualifications / Requirements
Brokers generally require you to have some experience and
to sign a form acknowledging the risks before they'll allow you
to sell options.
First Steps
If you don't already have an account with a discount broker,
open one. You need to keep transaction costs down with options
or you can easily pay out half of your gains in commissions.
Resources
http://www.optionsbuddy.com
- There is a covered call screener here that points out which
stocks have the most expensive calls--perfect for this covered
calls strategy.
http://finance.yahoo.com
- Great resource for stock prices, information, and you can just
click the options button to get lists of all the options you
can sell on a given stock.
http://www.tradeking.com
- This is one of the cheaper brokers, and I like their service.
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