Covered Call Case Study

8/8/2019 Covered Call Case Study

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App endix C Covered Ca lls: A Case Study

The p urpose o f this cove red c a ll (buy-write) strategy c ase stud y is to c om pare the results ofna ked stoc k ownership ve rsus the ow nership o f stoc k with c a lls written a ga inst it ove r time.

The rat iona le of this stud y wa s to see if the p rem iums c ollec ted from the sa le of the se c a lls eitherenhanc ed the p ositive return a bo ve the naked stoc k position a nd/ or provided do wnside

p rotec tion, p revent ing a loss eq ual to the loss inc urred by the naked stoc k during an a dversemovement.

For purpo ses of the stud y, c erta in rules were followe d to e nsure tha t the stud y wa s notc onta minate d with any type of outside influenc e such a s po sition ad justment o r disc retion.These typ es of results a re g ua ranteed by c rea ting c onsta nts. The c onstants in this stud y w ill be :

1. Ca lls w ill be sold in a 1 to 1 ra tio w ith the stoc k (one c a ll per every 100 sha res) ea ch andevery month.

2. The o ption tha t w ill be sold w ill be a t-the-money strike for eac h a nd eve ry mo nth.3.

The stoc k must b e reta ined e very month.

With these three rules, we assured tha t no expe rtise involving d isc ret ion, timing, or selec tionwould b e made. This gua rantees tha t the strategy itself and not the trained or professiona l useof it is being m ea sured .

The numbers a re rea l numb ers. All stoc k prices a re c losing p rices taken from either the NYSE orthe OTC. Op tion prices we re taken from the O CC.

The numbers p resented a re simp ly results. The stoc k results a re the p ric e where the stoc k sta rtedat the b eg inning o f the study versus the p ric e a t the e nd o f the study.

The o p tion results were c a lcu lated as follow s: First, the numbers posted a re results in terms of the

profit or loss of the op tion for the given m onth. This numb er wa s c alculated by finding thedifference b etwe en the op ening p ric e of the o ption on the d ay a fter expiration from theprevious mo nth and the c losing p ric e o f the opt ion a t its expirat ion o ne m onth late r.

After the sec ond mo nth, if the stoc k pric e w as low er than the c all s strike p ric e the op tion wa sout-of-the money a nd wo rthless. This me ant t he entire p ric e o f the op tion wa s c ap tured as apo sitive premium a nd is rep resented by a po sitive num ber. If the stoc k price finished abo ve thec alls strike p rice, than there we re tw o p ote ntia l ca lculations app lied .

The first p ossibility wa s if the stoc k pric e c losed above the strike p rice by less tha n the amount ofpremium ac quired in the sale of the op tion (the p remium w as greater than the a mount b ywhich the stoc k price e xc eede d the strike p ric e).

In that c ase the opt ion still ma de mo ney but the stoc k wo uld b e c alled aw ay. As pe r the rules,the stoc k would have to be retained so the p rofit of the op tion w as red uce d by the a mo unt ofthe stocks p rice excee d ing the strike p ric e. This offset t he loss of the stocks rete ntion c ost. Itwa s still rep resented by a po sitive numb er but a low er one.

The sec ond sc ena rio w as if the stoc k price e xc eed ed the strike pric e o f the c all by more tha nthe a mo unt of premium received from the calls sa le. In that sc ena rio, in order to reta in thestock, the c a ll (in theo ry) would ha ve to be b oug ht b ac k at a loss. This loss is rep resented by a


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neg ative numb er. This neg ative numb er (loss) allow ed for the retention of the stock in keep ingwith the rules.

By c alc ulating the results this wa y, the stoc ks c ap ita l loss or ap prec iation c an be isolate d in b oththe na ked strat eg y and the c ove red c all strate gy. This allows the a c tual premiums rec eived tobe sep arated from c ap ital loss or ap p rec iat ion fo r c om pa rison p urpo ses.

The stocks sta rting p rice is listed a long w ith the finishing p rice a nd t he p ercentage return. Also,ea ch month s op tion premium is listed and late r tota led .

From there the op tion return is added to the stoc k retu rn to g et a c ove red c a ll retu rn. This is thenused to ad just the ove rall return and finally is c om pared to the return of the stoc k only strate gy.

Plea se ta ke note tha t when loo king a t ea c h stoc ks op tion p rem ium return over the span o f themo nths in the study, there a re o nly two or three mo nths that show an op tion p rem ium with anega tive numbe r.

These neg atives a re not losses. They rep resent times of lost o pportunity c ost b ec ause in tha tmo nth, the stoc k trad ed at a bo ut the op tion b rea k-even p oint and your stoc k was c alled aw ayfrom you. The neg at ive numb er is the d ifference b etw een where your brea keven wa s and

where you need ed to b uy it b ac k in order to retain the stoc k.

This neg ative num ber is not lost mone y, just lost opportunity. For the purpose o f show ing ho w thestrate gy worked ove r the period of time selec ted , we neede d to forc e the retention of the stoc k.

Also, the results a re ta bulate d with no lean, just a p lain, va nilla sell the a t-the-mo ney-c a llexamp le of how the strategy wo rks without any outside influenc e just straight num bers. Inea ch case, with d ifferent stocks in different ind ustries, the b uy-write strategy out performed thestoc k only strate gy.

Bristol Myers Squib (BMY)

STOCK ONLY RESULTS

Start $23.89Finish $26.36

+$2.47 inc rease is a 10.34% return

MONTHLY OPTION PREMIUM RESULTS

10/18/ 02 +.8011/15/ 02 +1.1012/20/ 02 +.0501/17/ 03 +1.20

02/21/ 03 +.4503/21/ 03 +.6204/18/ 03 -2.4705/16/ 03 -2.2406/20/ 03 +.5007/18/ 03 +.4508/15/ 03 +1.00

TOTAL OPTION PREMIUM RECEIVED +1.46


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STOCK RESULT PLUS OPTION PREMIUM RESULT +3.93


Cisco Corp (CSCO)

STOCK ONLY RESULTS




10/18/ 02 -1.2811/15/ 02 +.5012/20/ 02 +.2001/17/ 03 +.5002/21/ 03 +.6003/21/ 03 +.3004/18/ 03 -1.3305/16/ 03 -.1306/20/ 03 +.5107/18/ 03 +.66

08/15/ 03 +.15

TOTAL OPTION PREMIUM RECEIVED +.68




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Oracle Corp (ORCL)

STOCK ONLY RESULTS




10/18/ 02 -.3011/15/ 02 +.2012/20/ 02 +.2001/17/ 03 +.3502/21/ 03 +.6503/21/ 03 +.2504/18/ 03 +.2405/16/ 03 +.18

06/20/ 03 +.8007/18/ 03 +.3508/15/ 03 +.55





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Bank One (ONE)

STOCK ONLY RESULTS


+$.70 inc rease is a 1.8% return


10/18/ 02 +1.3511/15/ 02 +.8512/20/ 02 +.05

01/17/ 03 +.6502/21/ 03 +.7003/21/ 03 +.9504/18/ 03 -1.6205/16/ 03 +.4606/20/ 03 +.2507/18/ 03 +.8508/15/ 03 +.80





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Affymetrix Co (AFFX)

STOCK ONLY RESULTS


-$1.50 de c rease is a 6.25% loss


10/18/ 02 -.4711/15/ 02 +.8512/20/ 02 +1.2501/17/ 03 +.5202/21/ 03 -.8703/21/ 03 +.80

04/18/ 03 -2.5305/16/ 03 +.6706/20/ 03 +1.0007/18/ 03 +1.1508/15/ 03 +1.25



+$2.12 increase is a 11.31% return


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COMPARISON

BMY

Stock Alo ne Return +10.43% ReturnWith Op tion Strategy +16.45% Return

CSCO


ORCL


ONE


AFFX

Stoc k Alone Return -6.25% ReturnWith Op tion Strate gy +8.83% Return

In eac h situation , ac ross a range of stocks in different scena rios, the results show tha t the buy-write strate gy works a high p ercentag e o f the time . Please not e tha t the increase in the rat e ofreturn is on ly half of the sto ry.

During the life of the p osition, the ac cumulate d p rem iums rec eived p rovide a protec tive c ushionag ainst adve rse stoc k moveme nt. Covered c all writing is not a lways profitable a nd w ill not w orkeve ry time . Choosing the right op tion to write a ga inst which stoc k, and whe n, a re c ritic a lelem ents in de termining c onsisten t returns and long te rm suc c ess.

CONCLUSION

The results of the c ove red c a ll (buy-write) stud y show tha t this strategy c an b e suc cessful ac rossa w ide range of stoc ks and ac ross a w ide range of va riables and trading p atte rns: A c loser loo kat the study ham me rs hom e som e interesting p oints.

First, when looking at the m onthly op tion p rofit and loss figures, we see that the o pt ion ma demo ney in 8 or 9 out o f the 12 months on e ac h of the five stoc ks. This see ms to c onfirm the stud iesthat sta ted that the sale o f premium w as the right trad e a bo ut 80% of the t ime .


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Sec ond , the strate gy w orked in the stoc k that w as do wn, the stoc ks that w ere stag nant andeven in a stoc k that wa s up big.

Third , the strategy see me d to p rovide e qua l returns for highe r volatility stoc ks as we ll as lowe rvola tility stoc ks. These num bers and sta ts show tha t the c ove red ca ll strategy d oe s wo rk. Thefollow ing c harts will show why and how the strate gy wo rked in the c ase studies.

Bristol Myers Squibb (BMY) Week ly Cha rt


9/18

________________________________________________________

Notes

Stock: Bristol Myers Squibb Symbol: BMY


10/18

The BMY cha rt show s a stoc k that ha d som e b ad new s ba c k in Ma rc h/ Ap ril 2002, trad ed dow n ind istressed asset fa shion, until reaching a leve l o f exhaustion in July/August 2002.

After that, the stoc k co nsolida ted into a new trad ing range as shown by the two c olored bo xesc onnec ted by the stra ight solid line. Our study w as cond uc ted during this pe riod o f time andwa s as suc cessful as it w as bec ause it w as c ond uc ted at this partic ular time .

From Oc tob er 2002 to O c tob er 2003, BMYs trading rang e t ighte ned . Take notice o f the m ovingaverage line m arked MA sta rting a round Ap ril 2003 through Oc tober 2003. The line is a lmostperfec tly flat for 6 whole months. This show s a rea l lac k of move me nt.

For a six month pe riod , this stoc k ba rely had a p ulse. A buy-writer ca n t ask for muc h mo re tha nthat . Not only d id it tighte n from a m onthly and w eekly perspe c tive but also d a ily and furtherintra-day.

This intra-day rang e d ec rea se c an be seen by the leng th of eac h da ily vertica l line. Theshortening of eac h individua l line indic ate s a c ontinuing sma ller and sma ller da ily trad ing range .

Although th is indica tes a d ec rea sing vo latility whic h in turn ind ica tes a sma ller premium, it a lsoindica tes a be tter chanc e a t c ap turing that p rem ium a nd do ing so on a more c onsistent b asis.

This buy-write w as a winner due to the c onsolida ting nature of the stoc k and the fa c t that soo nafter its de c line, the stoc k had a long pe riod when the trad ing range tightened .

Cisco Systems (CSCO) Week ly Cha rt


11/18

________________________________________________________

Notes


12/18

Stock: Cisco Symbol: CSCO

Cha rt 2, the C isco c ha rt, is muc h d ifferent tha n the Bank One c ha rt. The m oving a verage line(ma rked M A) has muc h mo re b end to it. It is not nea rly as flatte ned out a s the Bank Onemo ving average . This stoc k is not sta gnant.

Also, there do es not seen to be muc h g roup ing. Although there a re a ppa rently no simila rities,

the c ove red c a ll writing strategy wo rks in this situation a lso. Ag a in, I wo uld like to c a ll youratte ntion to 2 sep a rate po ints.

First, notic e the two boxes at either end of the grap h with the line c onnec ting the two boxes.Notice ho w straight the line is betw ee n the tw o b oxes. This indicat es tha t the stoc ks sta rtingpric e a nd ending p ric e a re a lmost the sam e.

During this two yea r spa n the stoc ks value d id not c hange muc h at a ll. The stoc k did fluc tuatedu ring t he 2 yea r span in betw een the starting pric e a nd e nd ing p rice b ut there wa s littled ifferenc e from sta rt to finish. So, we see little move me nt from sta rt to finish bu t som e move me ntin between. The lac k of mo vem ent of the sta rt to the finish co uld be a g ood sign for c ove redc all writing if the in be twe en is not to o vo latile.

The sec ond po int de als with the a rea be twee n the b eg inning a nd the end . As you c an see, thestock sta rts out in a d ow ntrend , bottom s out just befo re Oc tob er of 2002, and then sta rts into anupt rend that extends into Novem be r 2003.

There is no rea l g roup ing to b e found b ut there is anot her pa tte rn. In the up trend , there is a slow,grad ual upward step m oveme nt. No ma jor ad vances, just a slow, c onstant one sma ll step at atime m ove me nt. This move me nt is visible on the d ow nside a s we ll but not a s p reva lent as theupw ard rec overing movem ent.

There, the step by step upw ard mo vem ent is the slow, grad ua l, low volatility d irec tional mo vetha t serves c ove red c a ll writers we ll.

So, in this c ase, CSCO is stagnant from b eg inning to e nd , with low vo latility direc tiona lmo vem ent in betw een. Even thoug h the moveme nt is signific ant b etw een the start and finish, itis d irec tiona l and m ostly of low vo latility. This c om b ination bod es we ll for covered c a ll writing.

Orac le Corp (ORCL) Week ly Cha rt


13/18

________________________________________________________

Notes

Stock: ORACLE Symbol:ORCL


14/18

Loo king a t the Orac le cha rt, we c an see the rea son w hy the buy-write strate gy ha d suchsuc cess from Nov 2002 to Oc t 2003. Turn your attention to box 2.

Box 2 is loca ted roug hly around the time the study w as sta rted . From a pric e stand po int, thec enter of the box is a round $12.00. From this time a ll the w ay out to Oc t 2003, the stock is in ac onsistent sidew ays trading c hanne l. The c hanne l seems to ha ve a low of a bo ut $11.00 and ahigh o f ab out $14.00. Further, the line d rawn from box 2 to box 3 is a lmost to ta lly fla t a t roughly

the $12.50 leve l.

The stoc k travels up above the $12.50 range to about $14.00 then trave ls dow n through $12.50 toabo ut $11.00 and then bac k up a ga in. These mo ves are slow, smo oth movem ents bo th up a nddown.

These typ es of move s a re o f a c onsolida ting na ture and a re of a d ec reasing vola tility. This c ha rtshow s a g ood b uy-write oppo rtunity.

As this pa tte rn cont inues tow ard Sep tem ber 2003, we not ice tha t the stock sta rts to show highe rlows and lowe r highs. This show s tha t the stoc ks range is tighte ning a nd the stock is headedtowa rd a stag nant p hase.

Further, go b ac k to Oc tobe r 2002 and pa y c lose a ttention to the a ctua l length o f the vertic allines tha t signify the intra day rang e o f the stoc k. Now, if you sc an forward in time to wa rdOc tob er 2003, you see that the a verage leng th of the da ily rang e (vertic al) lines ge t shorter.

This indica tes tha t the stoc ks daily movem ents a re d ec rea sing a nd that the stoc k is not mo vinga round muc h. This patte rn ind ica tes a d ec rea sing volatility and a stagna ting stoc k. It confirmsthe patte rn we were see ing with the tightening trad ing range. Aga in, this is a g ood c andida tefor using the buy-writing strate gy.

Bank One (ONE) Week ly Cha rt


15/18

_______________________________________________________Notes

Stock: Bank One Symbol: ONE


16/18

The c hart of Bank One show s two very notab le p atte rns that c an be suc cessful to c ove red c allwriters.

The first is the mo ving a verag e line. It is the horizont al line stretc hing a c ross the c ha rt outlined inyellow a nd marked MA. The mo ving a verage is an indica tor that show s the ave rag e va lue of asec urities p rice over a pe riod of time .

As you c an see , the line is ba sica lly flat c onsidering the cha rt c ove rs roughly a tw o ye ar term.The flatness of th is line ind ica tes the stoc ks ac tua l volatility was low a nd the stoc ks mo vem entwa s stagna nt. A stagna nt stoc k scena rio, as we know, is a favo rab le co vered c all writingsituation.

The sec ond is a situation tha t I w ill c a ll g roup ing. On the cha rt, you w ill see seve ra l orange boxestha t enc ase seve ra l c onsolida tions. These c onsolida tions a re time g roup s rang ing from seve ra lwe eks to a few m onths of relative stag nat ion.

Loo k a t the first bo x ma rked 1. This period of time c ove rs approximately 3 mo nths and the stoc khad a two d ollar range.

Box 2 also ha s a stoc k rang e o f ab out tw o d ollars but the a pp roxima te time pe riod is c loser to

five m ont hs.

As you c an see , those b oxed group ings c onstitute a very large part of the stoc ks mo vem entsduring the 2 year pe riod . These large p eriod s of sta gnant time a llow for very suc cessful c overedcall writing.

Affymetrix (AFFX) Week ly Cha rt


17/18

________________________________________________________

Notes

Stock: Affymetrix Symbol: AFFX


18/18

Unlike our previous four exam ples, the stoc k price o f Affyme trix wa s ac tua lly do wn during thepe riod the study wa s c ond ucted .

Due to a neg at ive ne ws story, AFFX had a day whe re t he stoc k dropp ed ove r $10.00 fromaround $27.00 to a p rice of $17.00. The stoc k did rec ove r but still finished the p eriod dow n 6%.AFFX is a pe rfec t exam ple o f how the c ollec tion of p rem iums ove r time c an offset sma ll or evenmo derate losses.

The AFFX covered ca ll write wo rks for different rea sons tha n the p revious examp les. Loo king a tthe c ha rt we rec og nize a fam iliar patte rn. The m oving a verage line, which is relatively flat, isnorma lly a g ood sign for po tential co vered c all writing.

The p rob lem is that the stoc ks range off the mo ving average line is quite substantial in bo thd irec tions. The mo vem ents a re large and fa st signa ling highe r vo latility levels. Co mp aring theda ily movem ent ve rtica l lines to p revious exam ples you see how this stoc k has b igger da ilymo ves in ad dition to an ove rall wide r trading range .

The suc c ess of this c ove red ca ll is a com bination of t wo fac tors. The first a nd foremost is the sizeof the premiums.

The op tion p rem iums we re muc h higher bec ause of this stocks high vo latility. The large rpremiums ga ve us an extra protective c ushion a nd we need ed it.

From looking a t the c hart, you c an tell tha t this stoc k wa s all ove r the p lac e. The b igge rpremiums we re a he lp b ut they need ed to be co mb ined w ith another fac tor which ca used thestrategy to be suc cessful . . . luck.

We we re lucky enough tha t the stoc k wa s able to finish the pe riod in question som ew hat c loseto w here it had sta rted . During the p eriod , the stoc k saw a high o f over $27.00 and a lowaround $17.00. Since we were b lessed w ith a stoc k loss of only a c oup le do lla rs, the p rem iumswe re a b le to offset tha t loss and even provide us with a reasona ble g ain.

While our othe r examp les show the c ove red c all s ab ility to aug me nt g a ins, this exam ple show sthe c ove red c a lls ab ility to provide do wnside p rotec tion from a dve rse stoc k movem ent.

This illustrates how the covered ca ll strategy c an b e used as a defensive mea sure, as we ll as forprofit enhance ment.

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Covered Call Case Study