Covered Calls

What are covered calls?

Options contracts.

But first things first, what is a call option?

There are two basic categories of options, Calls and Puts. For now we are only concerned with Calls.

If you believe that a stock(or virtually any other traded asset) is going to rise in value in the future, you can enter into a contract with another person or entity, that will guarantee that you have the right, but not the obligation, to purchase that asset at a preset price any time on or before a preset date. But to secure that deal you have to pay a premium.

Lets see an actual example:



CHK is the ticker symbol for Chesapeake Energy Corp.

Today is September 7th 2008

Chk's price is $44.34



If you believe that CHK will increase in price to 60 dollars within the next 3 months.

you can buy an Call Option with a target price(strike) of 45 dollars that expires on the third Friday of January 2009.

This contract will cost you $580.

So what does all this mean?

If the price takes off and climbs up to, lets say $55 a share in two weeks, you can then opt to purchase shares of CHK for $45 dollars a share. How many shares? Each contract is for 100 shares. Or in this case $4500.

Wow! Buy 100 shares of a $55 stock for $45 a piece? A thousand dollar discount? whoo hoo! sign me up!

If you wanted to take an immediate profit you could then take those shares and sell them in the open market for the going rate of $55 per share or $5500 for a profit of $420 (Remember that the contract cost $580 in the first place). And don't forget commissions and exercise fees.
Or, you could just sell the contract itself.
That is generally what most traders do.
Well what's the contract worth now?
It isn't possible to know exactly to the penny but a pretty close estimate is around $1170, that works out to a profit of $590! That is before commissions and there are no exercise fees.

Much better huh?

So why not rush out and do just that?

Odds.
The odds are that over 90% of the time this contract will expire worthless because CHK will probably not rise that much in the specified time frame.
And that 90% applies to all option contracts! In other words most options buyers guess wrong.
So logically you would ask why not be on the other side of that trade?
Now that's a good question.

And the answer is that there is no good reason you can't.
IF, you do it carefully.

And there is a very safe way you can do it. And there is a way that practically guarantees profit.

Check this out;
First you buy 100 shares of CHK at the market price of $44.34, or $4434.00.
Then you sell (write) 1 call option contract.
This is called a covered call.

But what does it mean?

First you pick a price that you would be willing to sell your 100 shares. lets not get greedy how about 50 bucks a share? That's a nice $566 profit. and let's make the expiration time short, say 40 days, so we don't have to wait a long time to spend our money.

What money?

A 50 October call will cost the buyer $155. As the writer(seller) of the contract, you get that premium deposited in your account! and here's the best part, if the price of CHK doesn't hit $50 in the next 40 days you get to keep it and your 100 shares!

So what if it does hit $50?

You still keep the $155 dollars but you must sell your 100 shares at $50 per share, which is what you wanted to do in the first place. Only now your profit is not $566, it's $721 because of the premium you received for the contract. And that effectively lowers your initial purchase price to $42.79 per share which helps insure your initial investment if the price of CHK drops. You've got a built-in $1.55 cushion. And you can do it again every 40 days or sooner, or later. You pick the price and the time frame. But each time you do it you essentially lower your initial cost for the stock. Do it enough times and you can totally pay for the stock and get 100 shares of CHK for free!

So what are the drawbacks?

There really aren't any unless your tax situation is such that making a profit within the time frame puts you in a higher tax bracket or some other tax reason. But this is so rare that it hardly warrants mention. The only other risk here is the same as owning any stock. It can always fall in price. But as I pointed out, this trade only adds protection to the downside. You should only do this trade on a stock you want to own anyway.

OK, disclaimer and full disclosure time. Although I have, in the past, owned Chesapeake Energy Corp. I do not currently. I may in the future. Because I like the company. I am not recommending, for or against, any of the trade examples listed above. These examples are real world and current as of the time of this posting. The only thing I left out is the costs of commissions and fees, and that was strictly because it would have muddied up the water. Those costs must be accounted for in any trade you make. Furthermore, most of the online brokers offer training and learning centers that will go over Covered Call writing and you can always call your broker with questions, that is what you pay them for. If they don't or won't help you, find a new broker. I encourage you to research this strategy for yourself and understand it completely before you make this trade.

In closing this post I would encourage you to employ the power of covered call writing. It will bring in consistent income and add downside protection to your portfolio. If you change your mind and want to keep your 100 shares you can always buy back your own contract and by doing so, close out your contract. Depending on what the price of the underlying equity(the 100 shares of whatever) is doing, it may cost you more or less than the initial premium that you received. But I would recommend against doing this in most cases. Buying back your own contract is part of a good long term strategy but don't do it just because you think that you'll miss out on future higher returns. One in the hand vs. two in the bush and all that stuff. This strategy encourages you to take profits and keeps the gambling bug from stealing your profits. It is a great way to enforce self discipline. And if you've read my stuff in the past you'll remember that I believe that investor psychology is the biggest hurdle any investor faces. This Helps conquer that beast.

JT

Legal disclaimer: This post is for informational purposes only and is solely the opinion of the writer. Nothing in this post should be considered investment advice. Before investing in anything, the reader is encouraged to do his or her own research and consult with a certified financial advisor. Which John Tompkins makes no claim to be. John Tompkins and Toro Creek Investments accept no liability for financial losses or damages incurred by the reader because of this post.