Selling Covered Calls

The Smart Profits Report: Issue #270
Tuesday, December 27, 2005

Selling Covered Calls - Getting Cash for Stocks You Already Own
By Lee Lowell
Advisory Panelist, Mt. Vernon Research

If you own at least 100 shares of stock, and you’re not selling call options against it, then you are throwing away free money. How’s that?

Well, there are other traders out there who will give you money today for the right to take your stock away from you if it reaches a much higher price.

Selling covered calls is such a great strategy for padding your bank account that I still can’t believe there are investors who aren’t taking advantage of it. It’s one of the best ways to take in extra cash flow that you never thought you could have.

Here’s how it works…

Selling "Longshots" On Intel With Out-of-the-Money Calls

Let’s say you own 500 shares of Intel Corp (INTC) that you bought in 1997 for $25.50/share. How have you done?

Well, if you didn’t sell during the tech bubble in 2000, then you are breaking even as of today, with INTC trading for about $26/share. Bummer. All that time and you still haven’t made any money on it. You probably could’ve used that money to invest in something else, or at least buy yourself a nice gift after all that time. Who knew? Nobody knows how an investment will turn out over time.

What could you have done in the meantime? Sold covered call options against your shares. There are two great things about this strategy:

It allows you to passively accumulate income over time by having someone else pay you money. You become the option seller. For every 100 shares of INTC you own, you can sell one option contract. In this case, you can sell five option contracts.
It reduces your cost basis of the stock by the amount of the option you sold. If you sell enough covered calls over time, your cost basis could be zero! Let’s look at an example.

Below is an option chain for INTC with an April 2006 expiration date. The last price for INTC was $25.97 (upper right corner).

What we want to do is concentrate on selling out-of-the-money (OTM) call options. An OTM call option has a strike price that’s higher than the current price of the stock. In this example, we will focus on the $30 strike calls.

We see from the "Bid" column that the $30 calls are bidding at $.25. This means that for every $30 call we sell, we will take in $25 ($.25 x $100 multiplier). Since we own 500 shares, we can sell five option contracts and net a take-home pay of $125.

This strategy is great if we really like the stock and want to keep it in our portfolio. The only way we give up the stock is if it moves a good deal higher. Instead of waiting to see if INTC will ever go up in price, we are taking a proactive trading strategy and making some extra cash on the side.

What happens when we sell the $30 strike calls? It means that if INTC trades above $30 by April 2006 expiration, and stays above $30, we will be forced to sell our INTC shares to someone for $30/share. It’s called getting "assigned on our short options." But is that a bad thing?

Well, considering that INTC hasn’t been above $30 in almost two years, and you don’t really want to give up your shares, I don’t think it’s a bad bet. Plus, the trade is only good until April 2006. If INTC doesn’t get above $30/share by April 2006 expiration, then the trade is over and we get to keep the $125 free and clear… and we also keep our long INTC stock. We can also repeat the trade for a different expiration month.

If you happen to get assigned on your call options and are forced to sell the stock, then so be it. You still came out ahead. Not only did you make $125 from the options, but you also have a gain on the stock from your original purchase price of $25.50. That’s a $2,250 gain.

Using The Force When Selling Covered Calls

Selling OTM covered calls forces you to take some profits along the way (assuming you are selling calls with strike prices above your initial stock buy price). Also, since we are selling the calls for $.25, it reduces our cost basis to $25.25. Do that enough times over the years and your cost basis could be zero!

Some investors will worry about causing a capital gains tax event if they are assigned and forced to sell their shares. That’s true. But in my opinion, it’s better to take a profit somewhere along the way.

Would you rather hold your stock just to avoid the IRS? Look at all the stocks that have imploded since the 2000 meltdown. I’m sure there are many folks kicking themselves for not selling at some point, either through a regular stock sale or by an option assignment.

In the case of our INTC example, if we had been selling covered calls all along, taking in $125 once every three months or so, we could have netted a nice sum while the stock lingered for seven years. It’s sort of like a consolation prize while you’re waiting. Everyone else who didn’t sell covered calls has nothing to show for it.

This strategy is a way to gain sideline income while you wait for an eventual sell price (you do have a sell point, don’t you?) Why not sell potentially worthless options, repeat the process many times during the year, lower your cost basis and enjoy the income?

Today’s Smart Profits Cribsheet

Lee spent seven years in the options pits of the New York Mercantile Exchange (NYMEX)… And he’s taken us behind the scences to help us understand the role of the market makers. Check out his Market Maker Series, Smart Profits #241, #243, #247 and #252.
And if you haven’t looked into Lee’s special electronic report, How to Receive Instant Cash Payments for "Locking In" Lower Prices on Your Favorite Stocks, now is a great time to do so. It’s a handbook that can be e-mailed right to your inbox…
For a better understanding of terms like "covered calls" or "margin", check out our Smart Profits Glossary.