Full Disclosure Finance

By Andrew

In keeping with the options theme I decided to write a post on another fairly straight forward, easily applied strategy…covered calls. In this strategy an investors holds a long position in a stock and simultaneously sells call options on the stock to generate extra income from the position. A call option is a contract giving the owner the right (but not the obligation) to buy a specific number of the underlying shares at a specified price within a specified time frame. By selling calls against your shares you are selling the right for someone else to buy those shares at a certain price before a certain date. The price is determined by the strike price of the option and the date is determined by the option’s expiration date (options expire on the 3rd Friday of each month). To obtain this right the purchaser of the calls must pay you a premium, known as the option premium. Confused yet? Let’s take a look at an example to clear things up. Let’s say you own 1000 shares of XYZ stock currently trading at $25 per share. To generate some passive income from these shares you sell 10 May 2008 call options on XYZ at a strike price of $30. Remember each option contract represents 100 shares of the underlying stock so this transaction includes your entire position. The purchaser of the calls pays you the option premium of $1.00 per share (total of $1000). There are three scenarios that can play out from the time of the sale until the 3rd Friday in May:

1) The XYZ shares trade flat (somewhere below the $30 strike price). In this case the options expire worthless, you keep your shares and the premium from the calls. By selling the calls and collecting the premium you have outperformed the stock by 4%. You can repeat the process for the next option cycle, hopefully with the same outcome.

2) The XYZ shares fall in price. The options expire worthless, you keep the shares and the premium. Because you still own the shares you are on the hook for the decline in the stock price, but by collecting the option premium you have supplemented your losses. Once again, rinse and repeat.

3) The XYZ shares rice in price above the $30 strike price. In this situation the options are exercised and you are paid $30 per share for your position. Your upside is capped in this case at $31 per share (the strike plus the premium). If the stock had risen to $35 you would be missing out on $4 per share in upside.

In the covered call strategy you are reducing your downside risk by collecting the option premium each month. And because you have to own the underlying shares you would research the initial purchase just like with any other stock. If the option is exercised and you lose the shares, just take the 5-10% gain, plus any collected premiums, and move on to the next stock. Although the covered call can be implemented in any market condition, it is most often employed when the investor feels the stock will trade in a narrow range over the lifetime of the call contract. This strategy is a fairly simple one that anyone can do to generate extra income from shares they already own.

Stay tuned for a real world example of how to apply this strategy.