Covered Calls I - A Possible Place to Start
by Mike Parnos
When you embark upon your first adventure into options trading,
there are those who will tell you that "covered call writing" is
the safest strategy. Even brokerage firms allow novice option
traders to trade covered calls in their IRA accounts. Little do
they know. Or, if they really do know, little do they care.
Once upon a time there was an investor. All of his life he was
taught that, if you buy a stock and hold onto it forever, the
stock will go up, you make a lot of money and live happily ever
after. It's the American dream. As we've come to learn, those
dreams and Mother Goose have a lot in common. They're
fairytales. The harsh realities of the market have resulted in a
rude awakening. The internet bubble, bear markets, and an
abundance of corporate improprieties, have systematically
demolished hordes of retirement accounts. The "buy-and-holders"
are still "holding." Old habits die hard. Only, what they're
holding isn't hard anymore.
Some folks have portfolios of stocks they might like to use a
program of selling covered calls to generate some additional
income. There are good and bad points to this strategy. Let's
start with an overview of covered call writing along with a
basic example. Then, we'll delve into the nitty-gritty of it.
Covered Call: The Stock
For our example, we'll say you currently own 1,000 shares of
Juniper (JNPR) trading at $21.30. How you came to own this stock
is anybody's guess. Maybe you bought and held, maybe you
inherited it, maybe you won the lottery. It's not really
important. The question is - how can you best use this asset to
make money? You have a neutral to bullish outlook on JNPR. You
project that it will trade flat or possibly up a little in the
next few months. If your projection is just wishful thinking and
you have nothing substantial to base your opinion on, you have
no business owning a stock, let alone trying to trade options.
Covered Call: The Option
Well, if you've read my previous columns, you know that there is
a bottomless pit of speculators out there. "Speculators" is the
nice word. "Gamblers" is more accurate. There is, and will
always be, someone out there who is willing to buy an option -
betting that JNPR will rise substantially in the next month. He
is willing to buy the right to buy JNPR from you at $22.50
anytime between now and July expiration (about 6 weeks). For
that right he's willing to pay you $1.50 per share. That
translates into $1,500 worth of dead presidents into your
pocket.
The speculator is buying the JNPR July $22.50 call option. He's
buying the "right," but not the "obligation," to buy the stock
from you at $22.50. He's expecting that JNPR is going to
appreciate well beyond $22.50. If he's buying the stock at
$22.50 and the option costs him $1.50, his breakeven is $24.00.
The nice part about all this is that the $1,500 he's paying you
is yours to keep - regardless of what happens to the stock. It
shows up in your brokerage account the very next business day.
What you have to be willing to accept is the fact that, if JNPR
does happen to move up, you've agreed to sell it at $22.50. You
will not participate in any gains above and beyond $22.50. You
are trading the upside potential for the immediate, and
guaranteed, $1,500. See, everyone has his price.
More Profit Than You Think
Once you've accepted the possibility that your 1,000 shares may
soon leave home, you can focus on the potential profit in the
trade. If JNPR finishes above $22.50, there are two ways you
will profit.
1) You took $1,500 when you sold the call. That's a good start.
2) If your stock is called away at $22.50, you will have made
another $1,200 in profit from the appreciation of the stock
price. Remember, this all started with JNPR trading at $21.30.
When the stock is sold, you get the $1,200 difference ($1.20 x
1000 shares). You took in $1,500 from the sale of the option
plus another $1,200 profit from the sale of the stock - a total
of $2,700. That's a better than 13% return for a little over a
month. If you used margin to purchase the stock, it would be
about a 26% return.
If, at expiration, JNPR finishes below $22.50, you will still
own the 1,000 shares of stock and, if you choose, will be able
to sell another call for a future expiration cycle. In an ideal
world, you would be able to repeat the strategy month after
month. But, as we all know, we do not live in an ideal world.
The Good, The Bad & The Ugly
You now know the good. Get ready to learn about the bad and the
ugly. The main risk in covered call writing is the fact that you
do own the stock. And, contrary to popular optimistic thinking
of the masses, the shares of JNPR could go down just as easily
as it can go up. The $1.50 taken in from the option purchase
provides a little cushion - a damn little cushion.
The same principles apply to covered call selling as to all
other trading and/or investment strategies. The main principle,
and the toughest one to live with, is that you must have an
established exit point - and the self-discipline to act on it
when necessary. Of course, that means having to admit that
you're wrong when JNPR turns south instead of going up.
How do you figure out your exit point? There are a few ways.
1) Use a specific dollar stop. Your account management
techniques tell you that you have a maximum limit of a $2,000
loss per position. That would dictate that you have to close out
your entire position by selling your stock and buy back your
short JNPR $22.50 option when it costs you a total of $18.90
($18,900). 2) Check for support levels. There may be a support
level at $20.50. Maybe there's a 50-day moving average at
$19.55. You can establish an exit point if one, or both, of
these support levels are violated. For those of you who are
chomping at the bit to start trading, hang in there. There is a
lot more to know about these covered calls - and we will go over
it thoroughly in upcoming columns.
Missed Any Columns?
Hey, this is good stuff - especially if you're serious about
learning options. The Pulitzer people won't likely be knocking
at my door soon, but I've taught a lot of people how to
conservatively and consistently make money - and they're still
making money to this day. I hope you'll become one of them.
So, if you missed any of my previous columns, click on the
following link and, hopefully, they will magically appear.
www.tradingacademy.com/newsletters.shtm.
About the author:
Mike Parnos is known as "OTA's Options Therapist," Mike has been
trading, consulting and teaching option strategies for over 12
years. Both individually, and through his writings, Mike
specializes in teaching conservative and non-directional option
strategies while providing therapeutic guidance to thousands of
individuals, brokers and institutional traders.
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