Writing Covered Calls

The Smart Profits Report: Issue #128
Thursday, July 23, 2004

Writing Covered Calls: How to Double Your Profits with Stock Options
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

Writing covered calls is one of my favorite options techniques. At any given time, I’ll have more than 60% of my portfolio “covered” for one simple reason: I’m conservative.

I believe in mitigating as much risk as possible when I am investing in anything. Here, I want to show you how writing covered calls do just that.

Oh, and did I mention they’ll increase your profits, too?

How to Get “Premium Income”… By Renting Out Your Stocks

A covered call combines two instruments: an option and a stock.

It works like this: You buy shares of a company like Coca Cola at, let’s say, $50. You think Coke will go no higher than $55 in the next 12 months. If it goes higher, you will sell since that is your target price.

So far, that’s just normal investing. Well, if you can handle that, then why not make MORE money than just the $5 that you projected to make?

To do this you would WRITE (or sell) a $55 call option against your Coke position. You can sell one option for every 100 shares of stock you own. When you write a covered call, you will be obligated to deliver the shares if requested. That may or may not happen. Nonetheless, you will be sure to receive something for the option you sold. It’s called a premium. And it can amount to a good deal of money.

One way to view this premium is as rental income on your stock. You get the “rent” the minute you sell the option.

The transaction you entered - when you sold your call and collected your premium - has one consequence you have to find acceptable. It limits your upside gain on the stock to $55, since that is the strike price at which you’re obligated to sell your shares.

Writing Covered Calls - The Safest Way to Buy Stocks at a Discount…

That’s the way I see it. Writing covered calls is one of the best ways to make steady, conservative gains. Why should you care if the strike price is hit and the option buyer calls away your shares? You’ve already made the disciplined decision to sell at $55. So you’ll have all the profit you originally wanted from the stock… and more. (The premium you would receive in this case would be around $1.50.)

You can look at this as additional gains. I prefer to think of the money I collect writing covered calls as a way to reduce the cost of my stock. It goes like this:

The Coke stock costs $50. Your $1.50 option premium reduces your cost in Coke to $48.50. If the shares hit the strike price, your upside is now $6.50 (the $55 strike price minus $48.50, your base price per share) versus the mere $5 ($55 strike minus $50, the stock cost to you without an option).

You can see the difference. Buying Coke at $50 and selling at $55 is a nice 10% profit. When writing a covered call for another $1.50, it becomes a 13% profit… and that’s a very conservative example.

By writing the covered call you have accomplished two things:

Reduced your cost

Increased your upside.

All the while your target price has not changed.

If Coke closes below $55 at expiration, you keep your shares as well as the premium you received. If Coke trades above $55, then you’re obliged to sell at $55. This transaction (the sell at $55) will be done automatically by your broker.

Multiple Profits on the Same Stock

While the example I just gave obliged you to sell at the $55 level, there are ways to continue to build on your profits or to get out of the position early and profit again.

Let’s say that Coke was trading at $54 a month from expiration. At this point, it looks like the stock is going to go to $55 or more by expiration. You have two choices:

You can surrender the shares when they’re called away, as in the example above.
You can buy back your option so that you’ll be able to keep your shares and do it all over again.

Why would buying an option you previously sold make sense? After all, you decided you’d be fine with selling the shares at $55.

Well, here’s where an option seller takes advantage of time. When there’s only a month left on the option, you could now buy back your $55 call option on the cheap - for about 50 cents, this close to expiration. Then, you write another covered call going out another six to 12 months with the same $55 strike price.

Since the current share price is $54, you would pick up about $3 in premium for a 12-month option this time. (The closer the current market price of the stock is to the option strike price, the more valuable the option.)

Doing The Math When Writing Covered Calls

Now your adjusted cost per share would be:

$48.50
+ $0.50 (cost to buy back the option)
- $3.00 (premium received from selling the new option)
= $46.00 (your cost per share of Coke)…

So, you’d be paying and your upside would still be capped at $55. Now, instead of a 10% profit on owning the shares alone, you would make a 19% profit after selling calls twice before surrendering the shares at $55.

This type of strategy is especially effective on stocks that trade in a very narrow range or in a flat market environment.

Oh, and you may be wondering… Who is buying those options that you are writing? It’s the gambler who thinks Coke will go higher than $56.50 at expiration. His cost of owning Coke is $55 plus $1.50 (the amount he paid you for the right to buy your coke shares at $55).

I’m betting you’ll come out ahead on the deal…

Good trading,

Karim Rahemtulla

Today’s Smart Profits Cribsheet

Check out our Smart Profits Report Glossary for detailed explanations of options-trading terms such as “covered call” and “premium”.
To check out more information on covered call options, visit Mt. Vernon Research and view “The Income Trader - A Covered Call Strategy.”

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