The Breakdown Of A Covered Call Trade

The Smart Profits Report: Issue #370
Friday, November 10, 2006

The Breakdown Of A Covered Call Trade: How You Can Get Paid For Holding StocksBy Lee Lowell
Futures Options & Commodities Specialist, Mt. Vernon Research

I have a question for you: Are you making as much money as you can from your stocks? By that, I mean: Are your stocks just sitting in your account waiting to go up in price?

If so, it doesn’t have to be that way. Did you know that other investors will pay you cash today in exchange for the opportunity to possibly take your stock from you at a higher price sometime in the future? That’s right - you can earn passive income just because you have some shares sitting in your account.

Let’s see how it works through the breakdown of a covered call trade - showing you how you can put more money in your account today for holding those stocks…

The Anatomy Of A Covered Call Trade

If you own at least 100 shares of stock in your account, you have the opportunity to sell a covered call option against those shares.

What does that mean?

Basically, you can sell one call option (one option contract equals 100 shares) against the shares of the company you own to an option buyer.

In doing so, you’re giving up the right to own the shares to the person who buys the option from you. And when he buys, he now has the right to buy the shares from you at a pre-determined price (the strike price). For that right, he must pay you money - yours to keep, free and clear, no matter what happens in the future. That’s your return.

If the stock moves up past the strike price of the option you sold, you will then be obligated to sell your shares of stock to the option buyer at the stated strike price. Is that a bad thing? Not if you do the trade correctly, and have a price in mind that you would be willing to sell the shares anyway.

Let me give you a real-life example of how this covered call trade works…

Forget “Buy And Hold”: How My Folks Squeezed Extra Profit From IBM

My parents both own 800 shares of IBM that they’ve held for many, many years. Over that time, they’ve obviously experienced the ups and downs - but have still not cashed out of the stock.

But now, they’ve finally decided that if they’re going to sell their IBM shares, it’s going to be when the stock hits at least $95 or higher. Fair enough. But instead of simply having them enter a sell order limit at $95, I got them to sell some covered calls against their 800 long shares at the $95 strike price instead.

Since each option contract is the equivalent of 100 shares of stock, my parents sold 8 call option contracts each. Take a look at the IBM chart below:

We sold the first set of call options on March 17, 2006 - selling the January 2007 $95 strike calls for $1.95 each. That brought in an immediate $3120 (16 x $1.95 x $100 multiplier = $3120) into my parents’ accounts.

We chose the $95 strike calls because if IBM ever happened to trade above $95 by option expiration in January 2007, my parents would get the stock called away from them at that price. So instead of sitting around, waiting and hoping for IBM to eventually move back up to $95, they got proactive with their portfolio, sold some calls and made easy cash.

A Simple Buyback Worth $2,880

Since we’re never obligated to hold onto a call option, we decided to buy back the calls in the middle of July 2006 in order to take a profit on the option side of the trade. Even though IBM was moving down in price (and causing a paper loss on my parents’ long stock), the call options were getting cheaper too, giving us a gain on those.

We bought all the calls back for $0.15 each, which cost us $240 total (16 x $0.15 x $100 multiplier = $240). So in essence, we locked in a real-life gain of $2,880 ($3120 - $240 = $2,880). Sweet!

Since we bought the options back, we were left with no more obligation to sell IBM at $95/share. My parents had their 1600 shares of IBM just sitting in their account again. So what now? We wait for the next call option selling opportunity…

The Ride To $95 Is Much Sweeter With $4,800 In The Bank

That occurred about three months later, after IBM gapped up to $92 per share on October 18, 2006. Because IBM had rallied back by $18 higher per share, it was a good time to sell more calls.

My parents opted to sell the April 2007 $95 calls this time and collected $3.00 per option, which brought in another cool $4,800 of quick n’ easy money. Now all they have to do is sit and wait to see if IBM gets to, and then stays above $95 per share by the April 2007 option expiration.

If it does, they will sell their shares for $95 and walk away with no more position. If IBM stays below $95 at April expiration, the calls will expire, and my parents will keep their IBM shares and will look to do another trade sometime in the future.

So you can see that the covered call strategy is a sound and easy way to bring in extra cash every few months of the year into your portfolio. If you have stock sitting idle in your account, and have a pre-determined sell point, don’t just wait for the stock to reach that level, sell call options against your stock at a strike price that coincides with your sell point. Make your stocks work for you, instead of you working for your stocks.

Good Trading,

Lee Lowell

Today’s Smart Profits Cribsheet

Mt. Vernon Research Investment Director Karim Rahemtulla explains his own strategy for writing covered calls, showing you how you can “rent” your stocks, and gain income from them at the same time. You can get the details on covered calls now in Smart Profits #128, Writing Covered Calls: How to Double Your Stock Profits with Options.

And Karim should know. He’s a master of the covered call strategy (in fact, he’s got an entire trading service dedicated specifically to it - The Income Trader. Get more details!