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Covered Call Options
The Smart Profits Report: Issue #299
Tuesday, April 11, 2006
Covered Call Options: Turning A Stagnant Stock Into An ATM
By Lee Lowell
Advisory Panelist, Mt. Vernon Research
Many stockholders in Microsoft (Nasdaq: MSFT) have had little cause for celebration. For five years running, the company’s stock has been stuck in a tight trading range, bobbing and weaving between $20 and $30.
But some people are making a lot of money on the stock, and I’m not referring to billionaire Bill Gates… You see, when a stock you own is not performing or isn’t moving, you can increase your cash flow from it by using a very simple tool - “rental” income.
The strategy, of course, is “selling covered call options” or “writing covered call option,” and it’s employed by just a fraction of those who own stock. But it is one of the surest paths to making money from your investments. Here’s how it works…
How to “Rent Out” Your Stock For Extra Cash
Let me start off with the one catch (but don’t worry, it’s a good one). In exchange for someone paying you cash today to “rent” your stock, you have to enter into an agreement with them to possibly sell them your shares at a pre-determined price by a pre-determined date.
If the conditions for selling your stock don’t materialize by the pre-determined date, then you are off the hook and you get to keep the money you were paid upfront. In addition, you get to keep your shares of stock and the trade is over and done with. You are free to do whatever you want or you can enter into another contract.
The reason you buy stock in the first place is to gain capital appreciation and/or dividend income. But for much of the time, your stock may sit idle, or retreat, possibly leaving you with a loss. Selling call options against your existing shares allows you to take in money that you don’t have to give back. This money can be a cushion against your shares if they happen to fall in price. It also reduces your cost basis.
Here’s an example:
Above is a monthly chart of Microsoft going back to 2001. As you can see, the stock has been stuck in a 10-point range between $20 and $30. If you’ve owned any shares during that time, did you gain any long-term appreciation? Most likely not.
So, in those five years of bobbing and weaving, what could you have done to supplement your income? Sell covered call options. Let’s suppose that you own 300 shares of Microsoft. A stock option contract covers 100 shares of stock, so you’d be able to sell three covered call contracts. Let’s see what kind of money we could receive in today’s market for selling covered call contracts with MSFT stock trading at $27.64/share.
An Example of Selling Covered Call Options
Below are the option prices for MSFT for October 2006 expiration. When selling covered call options, you have to make a decision about the strike price. Since a majority of people would like to keep their shares for the long haul, we want to focus on strike prices that are at a level the stock is not likely to reach by expiration. These are called “out-of-the-money” (OTM) options.
We can sell the MSFT October 2006 $30 calls for $0.50 each, netting us $150 for our 300 shares of MSFT. That’s roughly a six-month holding period (from now until October). If MSFT never gets - or stays - above $30 by October expiration, we get to keep our $150 as well as our 300 shares of MSFT. At that point, we can repeat the trade again, like clockwork. The idea is to routinely write covered call options on the same stock.
Two Ways To Profit With Covered Call Options
If MSFT ends above $30 by expiration, we have two choices:
- We let our stock get called away from us and we are happy that we finally got to sell MSFT for $30/share (a level that hasn’t been seen in over four years!). Not only do we get to keep our $150, but we also got another $708 in appreciation from the move from $27.64 when we initiated the trade to our sell point of $30.
- If you are having second thoughts about having your shares called away, you can always buy back the option and your obligation to sell the shares disappears. This is not detrimental. Most people think that buying options back means taking a loss. But it is offset by the larger profit from the shares. So, even though you might take a loss on the options, your gain on the stock will be larger.
The bottom line is this: There’s an opportunity for you to make more money on your stock than just if the price goes up. Someone is willing to pay you money today for the possibility of taking your shares away from you at a higher level. Think of it as another perk to owning stock.
It’s even better if you think of it as a cushion against a potential downturn in the price of your stock. And, in the case of MSFT, you can do the trade twice a year and net $300.
If you did that over the last five years when the stock was trading sideways, you would have collected an extra $1,500. Not to mention that if you write enough covered call options, your cost basis for the stock could eventually become zero.
Good Trading,
Lee
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Today’s Smart Profits Cribsheet
- Remember, a deep-in-the-money option has a strike price significantly below (call) or above (put) the market price of the underlying asset. Investing in this type of option is similar to investing in the actual asset, except the buyer will benefit from lower prices, more leverage and more profit potential. For more important terms, see the Smart Profits Glossary.
- I’ve put together a special electronic report, How to Receive Instant Cash Payments for “Locking In” Lower Prices on Your Favorite Stocks. And if you own stock right now, I urge you to learn more about it. It’s a handbook that can be e-mailed right to your inbox… just click here.
Related Articles:
- Selling Covered Calls: Getting Cash for Stocks You Already Own
- Defensive Covered Call Strategy: What’s Better Than Making Money? Keeping It
- Buy-Write: Predict Your Profits With 99.7% Accuracy
