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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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