Learn the tools to protect your portfolio, Part 2

May 5, 2010 / Jeff McAllister

Trading Options by using “The Covered Call” strategy

In this post, I will discuss the second element of a collar trade – the covered call (often called the buy-write).

Stock ownership can be a very profitable approach to long-term investing. All you have to do is pick a stock with strong fundamentals, right? As Warren Buffet will tell you, a company that performs well will have the stock price follow. Well, sometimes… Sometimes the overall market doesn’t wish to trend higher and your carefully chosen stocks go nowhere at all. Wouldn’t it be nice if there were a way to still increase your portfolio’s performance even when the equity is trending sideways? Well, there is. It’s called a Covered Call. It is probably THE most popular and basic equity/option strategy known in the market place.

Simply defined, a covered call consists of the long stock and a short call. For those who are new to trading options, allow me to explain: A short call is a contract that obligates the seller (that’s where the “short” term comes in) to sell the stock at the strike price of the option sold. You see, for every option contract, there is a buyer (we refer to that position as “long”) and a seller (short). These two positions – long and short – constitute a single contract. Each contact represents 100 shares of the underlying equity. The long call (buyer) is buying the RIGHT to buy the equity at the strike price of the option for the life of the option. Who is this trader going to buy the stock from? You guessed it, the trader who is short (sold) that same option.

So, it works like this: Presume that you have 500 shares of AMR (I know, you don’t like the fundamentals of airline stocks, but being an airline pilot myself, I trade the airlines as I “know” them well and that provides me a bit of an edge in trading that others do not have. More on gaining an edge in the market in another blog…). The stock ebbs and flows and yet seems to go nowhere. What can we do to add some value to our portfolio? We can sell the right to buy OUR stock from us by selling a short call. So, if AMR is trading at $7.50, I could sell the May strike 8 short call for, oh let’s say .50. Not much, but each contract would bring in $50 (because a contract represents 100 shares), and since I have 500 shares I can write 5 contracts or 50 * 5 = $250.00 (less commissions). So while the stock is basically doing nothing, I can add a nice little cash flow piece to my portfolio. The return isn’t great, but it’s almost like “found” money.

By selling these strike 8 May short calls, I am OBLIGATED to sell my 500 shares of AMR at $8.00/share should my short calls be assigned. If AMR finishes below $8.00 at May expiration (the third Saturday of the month at Noon eastern), the options expire worthless and I keep the entire .50 from the selling of the calls. In effect, what I have done is to reduce my cost basis in the stock position by .50. So, if I had paid 7.50 for the stock, my cost basis would become 7.50 – .50 = 7.00. If it turns out that the stock goes up through $8.00 and my short calls are assigned, I will have a nice little profit of ~14.3% (1.00 / 7.00 = .1428). If the options expire worthless, my cost basis (or risk) in my AMR position has been reduced to $7.00.

Should AMR become bullish am I required to sit tight and do nothing? No. There are several things that you could do:

You could buy to close the short call (perhaps at a loss), and allow the stock to move higher unencumbered.
You could buy to close the $8.00 short call and then sell to open a NEW short call further out in time (perhaps June in this example) and at a higher (out of the money) strike price. This would allow the stock to gain more value before being sold at the new higher short call strike price.
You could simply allow the assignment of the $8.00 call, be happy with the 14.3% return and move on to your next trade.

One word of caution: You may have heard this strategy used as a defensive hedge in a bearish market. It really isn’t intended as such. The only protection that the covered call affords you is to the new lowered cost basis. Any further bearishness below your cost basis would be a loss to your overall portfolio. There are better strategies to protect your positions in the event of a bearish trend. If you haven’t already read Part 1 in this series – please do so. It is about hedging a position using the long put option.

As you can see, this very simple strategy can be an effective tool for an investor. If you are intrigued by the possibilities using options in your portfolio and interested in finding the most successful options strategy, I highly suggest that you take the time to study the craft and I would encourage you to become a student of ours at OptionsAnimal. I know, a shameless plug, but how else are you going to become proficient in the use of options if you don’t study and train??? Take the time to just check us out. It will be well worth it.

Jeff McAllister
OptionsANIMAL Instructor

Read Part 1 of Protecting your portfolio