In working with students for several years as a coach at OptionsAnimal, I have heard a story told so often it has become commonplace. It basically reads,
“I know how to make a stock go down. I simply buy shares.” Sound familiar? This can lead to great frustration and a lack of confidence in investors and
traders who are looking for share appreciation to achieve profitability in the market. One way to introduce multiple avenues of profit on share ownership
is to utilize the covered call.
Anyone familiar with technical analysis knows that stocks do not go up in a straight line forever. Equities experience periods of bullish price momentum
often followed by at least consolidation of the rally if not outright profit taking. For those who don’t want to buy and sell shares frequently, utilizing
the covered call can enable investors to stay in their equity positions but continue to have a piece of a trade making money during stagnant or bearish
equity movement. I like to think of this trade as a means of creating your own “dividend stream” on equities regardless of whether they pay a dividend or
not. Here’s how it works:
You purchase shares of XYZ because you have a longer term bullish thesis on this equity. The market as a whole, however, is in a consolidation pattern and
XYZ is participating in this stagnant market condition. You decide to sell an out-of-the-money call on your shares to create some income while you wait for
the bullish trend to continue. Your potential obligation in this short call is to sell shares at the strike of the call option. Your risk in this short
call is covered because you already own the shares. Determining which strike to sell for the short call comes back to your market observations and
familiarity with XYZ in its technical patterns. The short call acts as a ceiling on profitability so you must determine how close you desire that cap on
profits to be. The credit you take in on the short call reduces your cost basis – therefore your risk – in the trade. If you primary exit is to retain
share ownership, then you want this call option to expire worthless. You keep the credit you took in on the sale of the short call and can then determine
if you wish to sell another short call in an expiration series further out in time. The short call acts as a cap on profits but also gives the trade some
“cushion” against bearish price action. Here’s what a sample trade might look like:
Buy 100 shares of XYZ at $50.00/share
Sell the July 2013 strike 55 short call for $1.00/share ($100 credit)
Cost basis on share ownership = $49.00/share – this is also your break-even point on the trade through the 3rd Friday in July
Let’s assume that XYZ is still at $50.00 on the day of expiration for your short call. You didn’t profit on share ownership, but your strike 50 short call
will expire worthless enabling you to keep the entire $100 credit. This is your profit in the trade for this time frame. It actually represents a 2% return
during this time. Had you only owned shares, you would have no profit in trade. If the shares were to increase in value to $55, you would be profitable on
both the share ownership and the short call position. You also have a hedge on bearish activity down to your break-even point at $49.00/share. In essence,
we have created a structure that can be profitable in both bullish and stagnant market conditions – something you can’t achieve in simple share ownership.
If the stock runs past your strike 55 call option, you can make adjustments to this structure so that you are not left out of further bullish momentum. You
can also adjust the trade if the stock begins to exhibit greater bearish momentum in its price action. The flexibility inherent in this structure makes it
a favorite among knowledgeable option strategists. I can see why!
Karen Smith
OptionsANIMAL Instructor
