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The Basic Covered Call
by Michael Thomsett

A covered call is a conservative options strategy that, structured properly, generates double digit returns in your portfolio. As with all options, risks have to be understood before positions are opened.

Selling covered calls is probably the favorite strategy among traders who understand options, and for good reason. It is a safe strategy that brings profits into your portfolio without adding to market risk. The only serious risk to this strategy is the "lost opportunity" risk. If the stock price soars, shares are called away at the fixed strike price and those potential profits are lost forever. Covered call writers know this happens on occasion; but they accept that risk for the certainty of strong, consistent profits. So market risk - the risk of losing value - for owning shares is higher than writing covered calls, if only because earning premium income discounts your basis in the stock. For example, if you buy stock at $74 per share and sell a call for 1.32, you discount your basis to $72.68 per share.

In summary, when you write a covered call, you are putting 100 shares of the underlying stock at risk of exercise, in exchange for receiving the premium. So instead of the better-known long position (buy-hold-sell), selling calls is a short position (sell-hold-buy). Each call relates to 100 shares of the underlying stock, so the safety in the covered call comes from having those 100 shares to deliver if and when the call is exercised.

A few basics have to be remembered when writing a covered call:

1. Don't pick high-volatility stocks just for covered call writing. A common mistake is to buy stocks just to write covered calls. If you seek the best option return, you are going to end up with shares of the more volatile stocks, so this is a pitfall. First, pick the stock based on sound fundamental and technical tests, and then write covered calls.

2. Make sure the strike price is higher than your basis in the stock. Another mistake is to write calls with strikes below your basis in the stock. In the event of exercise, this creates a capital loss instead of a gain. For example, if you buy 100 shares at 38, don't sell calls with strikes of 35; focus on strikes at 40 or above.

3. Pay attention to dividends. Dividends are likely to represent t an important portion of overall return. So if you are looking at two companies and both are equally promising, go with the higher dividend yield.

4. Compare expirations to make the best choice. Look at a range of possible expirations. The ideal expiration will occur within two months, because time decay accelerates toward the end of the option's life. As a seller of the call, time decay works in your favor. As value is lost, it becomes possible to close the position with a "buy to close" order and take a profit.

5. Compare potential net return on an annualized basis. When you are considering two or more different expirations, remember to annualize the outcome; otherwise your comparison is not valid. For example, an October 75 call (one month to expiration) gets you a premium of 1.32 ($132); but the December 75 (three months) pays 2.35 ($235). Why not take the higher payment? If you annualize (based on the 75 strike), you find the following:

October: ( 1.32 / 75 ) x 12 = 21.1%

December: (2.35 / 75 ) x 4 = 12.5%

Annualizing is the adjustment you make to restate profit as if both positions were held for one year. This, the one-month calls are multiplied by 12 (months) and the 3-month calls are multiplied by 4. Clearly, the October calls yield much better annualized return. Also, clearing out the position in one month instead of three frees up capital to write an additional call much sooner.

The above example is based on the value of McDonalds (MCD) at the open of September 14, 2010. The stock at the time was worth $74.12 and the dividend yield was 2.95%. As long as the stock price remains below $75 per share, the October call will not be exercised. If the price moves above, you can avoid exercise by closing the short call or rolling to forward to a later expiration date; or, in the event of exercise, the following profits are earned:

Capital gain (based on value of stock at the analysis date:

Strike price ($75 x 100 shares)$7,500
Less: basis$7,412
Capital gain$88
Dividend (one quarter)$55
Option premium$132
Total income$275

A note on dividend: The payout date is September 16, but to earn that you would have needed to own shares on August 30, the ex-dividend date.

In the above summary of profits, confusion may rise from the fact that there are three separate forms of income. The capital gain should be annualized based on how long stock has been owned, but should not be counted as part of covered call income. The dividend yield depends on ex-date in order to be counted; for example, if you did not own stock on August 30, you would have no dividend yield. (This points to the importance of also timing stock purchase and picking strikes and expiration based on ex-dividend date to improve overall income.) Finally, the option premium has to be annualized based on the time between opening the short position and expiration date. (In this case, the annualized option return was 21.1%).

The covered call strategy is not as simple as it appears at first glance. The basics remain in place: You own 100 shares and you sell a call, which is conservative because the shares cover your risk. You keep the premium whether the call is exercised or expires worthless. You can also close out the position at any time. Beyond the basics, however, you need to watch strike and expiration to maximize annualized return, and to be aware of ex-dividend date to time stock purchases. There is more to the strategy than the basics, but it adds no market risk to the simple ownership of 100 shares, and it does yield double-digit returns.

About the Author

Michael C. Thomsett is author of Trading with Candlesticks and numerous other books on technical analysis, stock trading and options.

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