Today I’m going to discuss a strategy called “covered call writing.” This is about the only type of option strategy that is worth doing since the others generally require a lot of time and the odds are about 50-50 at best that you will make any money. Also, the transaction costs and taxes are high which further cuts into any profits. If you are wanting to just play around and get some excitement, feel free to take a small, limited amount of money (that you are willing to lose, because you probably will) and try to time the market and buy calls and puts. If you are serious about growing wealth, however, and want to make some income from your investments during stagnant periods where the market is not moving, covered call writing is a strategy to consider.
Covered call writing and its inverse strategy, collateralized put writing, is actually fairly conservative. For the basics of options see the previous post, http://smallivy.wordpress.com/2010/05/23/how-stock-options-work-the-basics/ . As stated there, a call is a legal contract that allows a party (the person who buys the call) to buy a fixed number of shares of stock at a pre-selected price (called the strike price) on or before a certain date (called the expiration date) from the person who created the contract, the call writer. Each call normally gives the party the right to buy 100 shares of the stock it is written on.
In exchange for this right, the call buyer pays the call writer an amount per call, called the premium. The premium value is generally set through an open exchange (the Chicago Board Option Exchange) at which options are traded in a manner like common stocks. Here, instead of trading shares of stock based on the share price, options are traded based on the premium value, with trades being made (contracts created) when a buyer and writer can agree on a premium amount.. The premium value goes up and down depending on a variety of factors related to how likely it is that the option will be worth anything before the expiration date and how much the option currently is worth (if it were exercised and the shares bought right now).
The option buyer is hoping that the stock will go up in price before the expiration date so that the option will be worth more and he can either sell the option to another person or exercise the option and then sell the shares. For example, if he has an option to buy XYZ corporation for $10 and XYZ is trading at $15, he can exercise the option, buy the 100 shares of XYZ for $10 per share, and then sell them for $15 per share for a $500 profit.
In covered call writing, the investor takes the part of the call writer. In order to write covered calls, an investor must have the shares in her account (if not, that is called “naked” call writing which is extremely risky) and be willing to part with them if the share price goes up. The investor then tells her broker that she would like to write covered calls on the stock, gives information on the expiration date and strike price, and either enters a market order or a limit order on what premium would be acceptable, just like with a stock. Note that the options markets set up specific strike prices and expiration dates, so the investor selects one of these based on the current premium offered and other considerations.
Once the option is written, the call writer begins to wait until the expiration date. If the stock stays below the strike price during that time the option will probably not be exercised and will expire, allowing the writer to keep the whole premium. This is like getting a dividend on the stock, which tends to average about 15-25% per year if done right. If the stock is above the exercise price the shares may be purchased by the call buyer or the writer must purchase another, offsetting call before the original ooption is exercised. If the stock drops in price the call writer will lose money but the premium collected will reduce the loss somewhat (which is why it is more conservative than buying stocks outright).
The beauty of the strategy is that it allows individual who have large stock positions and wish to generate current income to turn any stock into an income source. The premium will be considered a short-term capital gain for taxes. The downside is that it limits capital gains since if the stock moves above the strike price before the expiration date the shares will be purchased by the call writer and taken away.
In the next post I’ll discuss how to select which calls to write based upon the option expiration date and strike price.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.