As of 11/11/2019
  Indus: 27,691 +10.25 +0.0%  
  Trans: 11,030 -37.61 -0.3%  
  Utils: 830 -5.55 -0.7%  
  Nasdaq: 8,464 -11.03 -0.1%  
  S&P 500: 3,087 -6.07 -0.2%  
YTD
 +18.7%  
 +20.3%  
 +16.4%  
 +27.6%  
 +23.1%  
  Targets    Overview: 10/31/2019  
  Up arrow27,750 or 26,900 by 11/15/2019
  Up arrow11,300 or 10,100 by 11/15/2019
  Up arrow870 or 800 by 12/01/2019
  Up arrow8,500 or 8,000 by 11/15/2019
  Up arrow3,150 or 2,950 by 11/15/2019
As of 11/11/2019
  Indus: 27,691 +10.25 +0.0%  
  Trans: 11,030 -37.61 -0.3%  
  Utils: 830 -5.55 -0.7%  
  Nasdaq: 8,464 -11.03 -0.1%  
  S&P 500: 3,087 -6.07 -0.2%  
YTD
 +18.7%  
 +20.3%  
 +16.4%  
 +27.6%  
 +23.1%  
  Targets    Overview: 10/31/2019  
  Up arrow27,750 or 26,900 by 11/15/2019
  Up arrow11,300 or 10,100 by 11/15/2019
  Up arrow870 or 800 by 12/01/2019
  Up arrow8,500 or 8,000 by 11/15/2019
  Up arrow3,150 or 2,950 by 11/15/2019

Bulkowski's Covered Calls

 

This article discusses the ins and outs of covered calls, prompted by an article in Active Trader magazine by Casey Platt, titled, "Earning dividends with covered calls." You can use covered calls to increase your return, but it also means a commitment to selling your stock.

 

Covered Calls: Background

If you trade stocks long enough and read financial magazines or books, then you will probably come across options, specifically covered call options. A call option gives the buyer of the option the right, but not the obligation, to buy the stock at a fixed price for a limited time.

For example, if you think IBM is going to go up in price, you might want to buy a call option instead of the stock. The option is cheaper than owning the stock and if you're right, the option's price can shoot up. If you're wrong or if the move doesn't occur by the time the option expires, you'll lose the money you paid for the option. You can always sell the option and get part of that money back before expiration, of course.

A covered call means that you own the stock. When you write a covered call, you are selling someone the option to buy your stock at a fixed price for a fixed time and collecting what's called a premium for doing so.

Let's say that you own 100 shares of IBM, bought on the close of October 23, 2009 at a price of 120.36. The November 120 calls sell for $2.70 each. If you sell one contract, you will make 100 shares x 2.70 or $270. The option will expire November 21st at an exercise price of 120. If the stock is above 120, then you risk the stock being called away from you, meaning you will be forced to sell it for $120 per share, regardless of how high the stock is then trading. If the stock's price is below $120, you will make money providing it doesn't drop below your break even point, which is 120.36 - 2.70 or 117.66, and you get to keep the stock and do the same thing all over again.

If the stock drops below break even, then you will lose money, tempered by the premium you earned by selling the call (in other words, the pain is lessened by $2.70 a share, but it's still a loss).

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Covered Call Scenarios

Here are some scenarios.

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Covered Call Recommendations

Here is what Platt recommends. My comments are in parentheses.

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Covered Call Example

Platt gives this example for Research in Motion, RIMM.

DescriptionEntry July 10Exit July 16
Buy 100 Shares-$6,595$7,192
Sell August 65 call+$500-$817
Total:-$6,095$6,372 or $280 profit

Assume you buy the stock on July 10 at a price of $65.95 (which is a cute trick since the low for that day was 66.10, according to yahoo!finance, but I'm just being a pest) and sell a call option for $5 per share, or $500, covering those 100 shares. That effectively lowers your purchase price to $60.95.

Six days later, the stock has moved up to 71.92 and you decide to sell it. However, the call option is in the money so buying back the option will cost you $8.17 per share or $817 for 100 shares. Even so, that means you make $280 in six days. He writes, "...Too many people focus on an option position's possible gains at expiration. Waiting until then doesn't always make sense, especially if the underlying climbs sharply and allows you to capture most of the position's potential gains within just a few days." In the RIMM example, the $280 profit is 70% of the potential $405 gain ($500 premium - $95 in the money at purchase time).

What he doesn't tell you is that just buying the stock at $65.95 and selling it at $71.92 would have made more money: $597, or more than double what he made using options. Oops.

Holding the option to expiration would not have been a good idea either. The stock closed on Friday August 21 (the day before expiration) at 77.32. The stock would have been called away at 65, so you would have missed out on $637 (77.32 sell price - 65.95 stock cost + 5.00 premium).

Covered Call Summary

As I mentioned in the recommendations, I write covered calls on stocks I expect to move sideways. You can make a good return by selling covered calls but your turnover will increase and you will miss some of the upside, especially in this bull market.

-- Thomas Bulkowski

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See Also

 

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