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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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The purchase of a stock (or futures contract) and the sale of a call option against the purchased underlying assetCOVERED CALL Covered call writing (selling) is the strategy that seems to be promoted most by the investment community. Many stockbrokers use this technique as their primary options strategy, perhaps because it is the one technique they are trained to share with their clients. It is also widely used by many so-called professional managers. Nevertheless, it can be a dangerous strategy for those who do not understand the risks involved. A few publications describe this technique as a get rich quick method for investing in the stock market, but it can become a get poor quick strategy if done incorrectly. What is this technique all about? The purpose of the covered call is to increase cash income from a long stock or futures position. It provides some protection against decreases in the price of a long underlying position or increases in the price of a short underlying position. A covered call has limited profit potential and can result in substantial losses; but these potential losses are less than those for an unprotected long stock or futures position. A covered call write is composed of the purchase of a stock (or futures contract) and the sale of a call option against the purchased underlying asset. Remember, the buyer of a call option has the right to call the option seller (writer) to deliver the stock at the price at which the option was purchased. Therefore, if you write an option you are the seller, and you are responsible for delivering the stock at the strike price at which the option was sold to the purchaser if the option is exercised. At the inception of the transaction, you receive a premium, which pays you for the time value of the option as well as any intrinsic value the option may have at that time. You may be wondering what is wrong with the whole concept of covered call writing. Why are so many people incorrect when they use this strategy? Many traders simply do not know the risks they are assuming when they implement this overused technique. If you placed covered calls in stocks that only go up, you could make out very well. However, how many people pick stocks that only go up? A range-bound stock exhibits price action between two specified points: resistance and support. Resistance is the point at which prices stop rising and tend to start to drop. Support is the point at which prices stop dropping and tend to start to rise. When a stock rises, it hits a certain price where the sellers rush in, outnumbering the buyers, and thereby causing prices to start to fall off. The support level is the place where the price has become low enough for buyers to start to outnumber the sellers and the price begins to rise again. If this recurs over a specified period of time (e.g., six months), strong support and resistance levels have probably been established. Stocks that exhibit these tendencies can be excellent candidates for covered call writing. However, you must be aware that nontrending stocks also can begin trends, and many may begin trending to the downside. Covered Call Mechanics Lets create a hypothetical example using a technology stock with the name XYZ Computer Corp. The ticker symbol for shares is XYZ and the company is one of the worlds leading computer sellers. The company has performed exceptionally well, with shares rising more than 400 percent in a one-year period! Lets say XYZ Computer is trading at $49 per share after numerous stock bonuses, and we decide to place a covered call trade. Lets buy 100 shares of XYZ at $49 each. This part of the trade costs $4,900 ($49 100 = $4,900). The amount of margin (the capital required) would be half this amount, or $2,450. In a covered call strategy, a trader offsets the purchase cost of shares with the sale of a call option. The covered call consists of selling one call for each 100 shares owned. The call can have any strike price and any expiration; however, this step can be difficult. You have to choose which option to sell. You have a multitude of choices: near-term, long-term, in-the-money, out-of-the-money, at-themoney, and so on. Many covered call writers sell options one or two strikes out-of-the-money (OTM) because they want the shares to have a little room to run up before reaching the strike price at which the option was sold. Lets say that on September 9, XYZ is trading at $49, and the October 50 and 55 call options (which have 40 days to expiration) have the following option premiums: October 50 Call @ 2.75. October 55 Call @ 1.75. In this example, lets go long 100 shares of XYZ at $49 and short 1 XYZ October 50 call at $2.75. This transaction has two sides, the debit (purchase of shares) and the credit (sale of option). The debit equals $4,900 ($49 100 = $4,900); however, the amount of margin (the capital required to place the trade) would be half this amount, or $2,450. In addition, you would receive a $275 credit (2.75 $100 = $275) for the short option on 100 shares of stock. The risk profile for this trade is shown in Figure 4.12. If the stock rises from $49 to $50, the strike price of the option, you make an additional $100. You also get to keep the $275 credit you received. In total, your profit will be $375. If the stock goes to $55 you still get $375. If the shares go to $100 you still get only $375. In both these instances, you have to deliver the shares to the assigned purchaser of the option as it will be exercised at expiration since the option is in-themoney (i.e., the share price is greater than the strike price of the option). That means that for an investment of $2,075: ($2,450 - $375 = $2,075), you can make $375 if the stock rises to at least $50 by expirationa 17 percent return in only 40 days. Lastly, the breakeven of a covered call is calculated by subtracting the credit received on the short call from the price of the underlying security at trade initiation. In this trade, the breakeven is 46.25: (49 - 2.75 = 46.25). In Figure 4.12, the risk graph for the covered call example, notice how the profit line slopes upward from left to right, conveying the traders desire for the market price of the stock to rise slightly. It also shows the trades limited protection. As XYZ declines beyond the breakeven (47.25), the value of the stock position plummets as it falls to zero. Thus, the inherent risk in this strategy rears its ugly head. Overall, the covered call offers a slightly better approach than if you simply purchase the stock at $49 and watch it drop, because you have reduced your breakeven price by 2.75 points. XYZ must drop below this new breakeven price (46.25) to start losing money at expiration. But once it falls below the breakeven, losses can accumulate quickly. Now lets say you sell the October 55 calls at 1.75; then your breakeven price is higher at $47.25 ($49 less the 1.75 received for selling the 55 call). By selecting the higher strike call option to sell, you will receive less of a credit and will raise your breakeven price for the stock. However, then you have a greater potential return on the investment if and when the stock goes up. Obviously, you lose money when the stock goes below the breakeven price. Bottom line: each option has a certain trade-off for the option writer. You have to decide which one best fits the market you are trading. As mentioned previously, if the price of XYZ stock has been going up significantly over the past year, covered call writing would not have hurt you. You may not have received the 400 percent gain stock purchasers received, but perhaps you could have slept better at night, as you would have reduced your breakeven point. Unfortunately, traders may select stocks that have just begun a tailspin and lose 50 percent of their value overnight. In these cases, a covered call strategy will not help. These traders may get to keep the short options credit, but that will not go very far in light of losing 50 percent or more on the total price of the stock. There are numerous examples of companies losing 30 percent, 40 percent, 75 percent, or all their value in one day. Do not count on this strategy to save you from losing large sums of money if the stock makes a big drop. Writing covered calls can work. However, you must find stocks that meet one of two criteria: trending upward or maintaining a trading range. As exhibited with XYZ, covered calls work well with stocks on the rise. Unfortunately, even stocks with upward trends have moments in which they make sharp corrections. These periods are difficult for covered call writers as they watch their accounts shrink, because the covered call does not offer comprehensive protection to the downside. However, in many cases good stocks will rebound. If you do choose to write covered calls, do so only in high-grade stocks that have been in a consistent uptrend and have exhibited strong growth in earnings per share. To protect yourself from severe down moves, you can combine covered calls with buying puts for protection. If you purchase long-term puts (over six months), you can continue to write calls month after month, but you will have the added protection of the right to sell the underlying stock at a specific price. Exiting the Position Since a covered call protects only a stock within a specific range, it is vital to monitor the daily price movement of the underlying stock. Lets investigate optimal exit strategies for the first covered call example, the sale of the 50 call. XYZ rises above the short strike (50): The short call is assigned. Use the 100 shares from the original long stock position to satisfy your obligation to deliver 100 shares of XYZ to the option holder at $50 a share. This scenario allows you to take in the maximum profit of $375. XYZ falls below the short strike (50), but stays above the initial stock price (49): The short call expires worthless and you get to keep the premium ($275) received. No losses have occurred on the long stock position and you can place another covered call to offset the risk on the long stock position if you wish. XYZ falls below the initial stock price (49), but stays above the breakeven (46.25): The long stock position starts to lose money, but this loss is offset by the credit received from the short call. If XYZ stays above 46.25, the position will break even or make a small profit. XYZ falls below the breakeven (46.25): Let the short option ex pire worthless and use the credit received to partially hedge the loss on the long stock position. Covered calls are one of the most popular option strategies used in todays markets. If you want to gain additional income on a long stock Covered Call Strategy: Buy the underlying security and sell an OTM call option. Market Opportunity: Look for a bullish to neutral market where a slow rise in the price of the underlying is anticipated with little risk of decline. Maximum Risk: Limited to the downside below the breakeven as the stock falls to zero. Maximum Profit: Limited to the credit received from the short call option + (short call strike price - price of long underlying asset) 100. Breakeven: Price of the underlying asset at trade initiation - short call premium. Margin: Amount subject to brokers discretion. position, you can sell a slightly OTM call every month. The risk lies in the strategys limited ability to protect the underlying stock from major moves down and the potential loss of future profits on the stock above the strike price. Covered calls can also be combined with a number of bearish options strategies to create additional downside protection. Covered Call Case Study Covered calls are often used as an income strategy on stocks that we are holding long-term. They also can be used as a short-term profit maker by purchasing the stock and selling the call at the same time. The idea is to sell a call against stock that is already owned. If we do not want to give up the stock, we must be willing to buy the option back if it moves in-themoney. However, if we feel the stock will not rise above our strike price, we would benefit by selling the call. On December 1, 2003, shares of Rambus (RMBS) were falling back after an attempt to break through resistance at $30. The stock rose to a high of $32.25, but ultimately ended flat on the session right at $30 a share. Viewing the chart, we might have decided that $30 would hold and that entering a covered call strategy might work well. By entering a short call, we have unlimited risk to the upside. However, by owning the stock, we mitigate this risk because we could use the stock to cover the short call. Lets assume we didnt already own Rambus, so we need to purchase 500 shares at $30 and sell 5 December 30 calls at $2.05 each. Our maximum profit for this trade is $1,025 [(2.05 5 ) 100] and this occurs if the stock is at or above 30 on December 19. The maximum risk is still large because the amount of the credit for selling the calls does little for a major drop in the stock. Our breakeven point is at 27.95, which is figured by taking the credit received and subtracting it from the price of the underlying at trade initiation (30 - 2.05). Figure 4.13 shows the risk graph for this trade. Though we have limited our upside risk by using stock to cover the short call, we still have significant risk to the downside if the stock were to fall sharply. However, if the stock remains near $30, we get to keep the entire credit, even though there wasnt a loss in the shares of stock. Since the passage of time erodes the value of the option, its best to use shortterm options. In our example, shares of RMBS did try several times to break higher, but each time resistance held and the stock ultimately closed at $26.37 on Covered Strategy: With the stock trading at $30 a share on December 1, sell 5 December 30 calls @ 2.05 and buy 500 shares of Rambus stock. Market Opportunity: Expect consolidation in shares after failure to break out. Maximum Risk: Limited as the stock moves lower (as the stock can only fall to zero). In this case, the loss is $790. Maximum Profit: Credit initially received. In this case, 5 calls @ 2.05 each = $1,025. Breakeven: Price of the underlying asset at trade initiation - call option credit. In this case, 27.95: (30 - 2.05). Margin: None. expiration December 19. At expiration, the stock position was down $3.63 a share, or $1,815: (3.63 500). However, the loss was offset by the $1,025 received from the credit from the short calls. So, the trade results in a $790 loss. A trader could continue to sell calls against the stock each month if it is felt the stock will remain near the strike price. |
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