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Writing Covered
Calls
Would
you like to reduce the risk of trading stocks and increase
the odds of a solid return on your holdings? What if you could
effectively buy stocks below their market cost? What if you
could reduce the size of the loss you have on a losing position
and increase the gain you have on a winning position? All
these goals can be accomplished using the same conservative
strategy that many investors and traders have used for years:
writing covered call options against a long stock position
they hold. The strategy is called covered call writing because
you already own the stock that you might have to deliver if
the buyer of the option decides to exercise the option. If
you didn't already own the stock it would be referred to as
naked call writing, i.e. you would have to go into the market
and buy the stock at the prevailing market price to deliver
the shares if the option was exercised by the buyer of the
option. This can be very expensive! Naked call writing
is considered very speculative and brokerage companies require
significant margin positions to engage in naked call writing.
Let's look at a couple of examples of covered call writing
and how they could contribute to your bottom line. If you
purchased 100 shares of AOL at $75 your cost is $7,500. If
at the same time you wrote a call option with a $90 strike
price and a February expiration date, you would receive the
$265 premium credited to your account. So effectively, you
purchased your shares at 72 3/8 instead of 75. Now it would
make no sense for the purchaser of the call option contract
to exercise their right to buy the shares from you for $90
a share unless they cost more than $90 in the open market.
So, if the price of AOL stays below $90 during the life of
the option, you simply get to keep the $265 premium. If the
option expires and you're holding your shares long term, you
may even want to write a new option against the shares you're
holding and collect the premium from the new contract. Now
if the share price of AOL rises above the strike price, say
to $95 your shares may or may not be called away from you.
Let's look at a couple of scenarios. The holder of the option
may decide to exercise the option, in which case you have
two methods to unwind your obligation. You could deliver the
shares and receive $90 for them for a $1,500 gain plus the
$265 option premium. Yes, you had your shares called away
from you, but you knew in advance at what price that might
occur and what percentage and dollar gain you would receive.
The other way to unwind your position if you wanted to keep
your shares of AOL would be to go out into the market and
buy a February call option effectively closing out the option
you wrote and shifting the responsibility to deliver the shares
to someone else. This offsetting position might cost you more
or less than the premium you received, but would allow you
to keep your shares, which may make good tax sense for the
buy and hold investor.
Now another outcome needs to be factored
into the mix: even if the market price rises above $90 strike
price, the holder of the option may only be speculating on
the option contract and may never exercise the right to buy
the shares from you. (Buying the shares still requires the
buyer to put up $9,000, where the person speculating in the
options contract only needs a couple of hundred dollars to
buy the contract.) You need to keep in mind that your option
positions only remain a covered position as long as you hold
the shares. If you decide to sell your shares prior to
the option expiration you would need to go into the market
and close out your position by buying a call option matching
the contract you wrote. Writing and unwinding options contracts
can get tricky. This isn't meant to be a definitive article
on writing covered call options, but rather to give you an
overview of one of the possibilities available to our clients.
We recommend you do further reading or consult your financial
advisor.
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