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FFO Options 10: Mastering The Covered Call Part IDr. Scott BrownStock Options

1Covered CallsRequire you to own the stock.

Are initiated by purchasing stock and often exited by selling stock.

May contain an unforeseen risk depending on subtle changes in the way the strategy is carried out.

2 Covered Call StrategyFirst you buy the stock and then sell (or write) a call option against those shares.Shares of stock can be bought at the same time the call is written.This is called a buy-write order.There is a balanced ratio of 100:100 when you write a call option for every 100 shares you own.Ex.: 100 shares; one contract, 200 shares; two contracts.For every call option you sell, you have the potential obligation to sell 100 shares of stockThat is why you have to buy 100 shares when you enter a covered call position. 3 Covered Call StrategyWhen you sell a call option without owning the stock you own a naked call.You must go into the open market and buy the stock.This is what happens when you write options that represent a greater number of shares than you own.With a covered call , the upside risk is eliminated since you own the stock.

4 Covered Call StrategyIf you remain in the covered call position, you have limited upside potential since the most you will ever receive for you're shares is the strike price.Its designed for investors who have a neutral to slightly bullish outlook on the stock.You should not write calls on stock you feel will move explosively upward or downward in share price.

5 PhilosophyThe main goal of the covered call is to collect MANY option premiums over a long period of time.Every time you write a call option, you are lowering the cost basis of youre shares.This reduces risk since you are reducing the amount of cash in the position.Covered call investors are not attempting to profit from rising prices.

6 PhilosophyJohnson and Johnson (NYSE:JNJ) is an excellent dividend paying stock that has been moving sideways for a year.

7 PhilosophyJohnson and Johnson (NYSE:JNJ) has the following expirations in my TDAmeritrade account.

8 PhilosophyJohnson and Johnson (NYSE:JNJ) a good strike to sell would be the 65 call with 68 days to expiration.

9Covered Call BasicsAssume you buy 100 shares of JNJ for $64.91 and then sell a $65 January call for the current $1.70 bid that has a $1.74 ask if you want to buy back the option.By selling the call you will receive $170 ($1.70 bid X 100 shares = $170)Value of the stock is $6,491 (100 shares*$64.91 = $6,491)Account will show a loss of $4 = ($1.70 bid-$1.74 ask) X 100.

10 Covered Call BasicsThe cost basis for the last slide is:$64.91 - $1.74 cash for the option = $63.17 per share.$18.81 per stock - $4.40 cash for the option = $14.41 per stock.If the call option ratio is different from 1:1, then you must use the weighted average to find the cost basis for the JNJ stock.If you own 200 shares, cost basis is $64.04 (200 X $64.94 = $12,982; 12,982 - $174 = $12,808; $12,808/200 shares = $64.04 per share).

11 Covered Call BasicsThe Exercise value for the contract is $6,500 ($65 strike price X 100 shares).The most a covered call writer can ever make on the stock is the $65 strike price at expiration.This means no matter how high the price of the stock rises, the covered call writer gains a limited amount.

12 Return if ExercisedFind the percentage increase between the cost basis and the strike price to help determine if the trade is appealing.The maximum return for the covered call is 2.9% in 68 days:$65 strike price - $63.17 cost basis = $1.83 gain. $1.83 gain/$63.17 cost basis = 0.029 =2.9%.The annualized figure for this return is 491%:365 days/68 days = 5.4 trades per year.5.4 trades X 2.9% return = 15.66% year end return.Higher return = Higher risk; Lower Return = Lower RiskHigh volatility of a stock means it could rise or fall substantially.You must be willing to own the stock.

13Static ReturnAnother way to determine if the trade is appealing is static return. This measures how the strategy would perform if the stock closed at the current price at expiration; 2.9% in our case.$64.91 current price - $63.17 cost basis = $1.74 gain.$1.74 gain/$63.17 cost basis = 0.027 = 2.7% return.

14 Break Even ReturnWe want to calculate how much the stocks price can fall to break even on the investment.$63.17 cost basis - $64.91 current price = -$1.74 loss.-$1.74/$64.91 = -0.027 = -2.7% drop in price.This gives you an idea of the downside hedge in the strategy.The size of the hedge depends on the premium you receive from the sale of the call option.The share price can drop to $63.17 before the position incurs a loss on the stock. We can afford a 2.7% drop in return before we begin incurring a loss on the stock.

15 Max Gain, Max LossThe maximum gain you can get from a covered call is the amount of premium received from the sale of the call plus the exercise price of the call. Above that point losses on the call are fully covered by appreciation in the stock. The maximum loss you can get from the covered call is the amount of the cost basis of the investment. Below that point you lose on the stock but not the call.

16Stay In Until Expiration?There is nothing that says you must remain in the covered call until expiration.If you buy back the contract, you regain full control of the stock and reap all upward appreciation.Using our JNJ stock example, if you buy back the contract for $1.00:Cost basis is $64.17 ($63.17 cost basis + $1.00 buy back) $16.41 ($14.41 cost basis + $2 buy back)The new return is 1.2% ($64.91/64.17 = 1.012 1= 1.2%).

17Stay In Until Expiration?If the stock rises from $18.81 to $20 and the option prices rises from $4 to $6:New cost basis for buying back the contract is $20.41 ($14.41 +$6).There would be a slight loss on the account since you would be able to sell the stock for the $20 strike price. The new cost basis for this scenario is $20.41.

18 Do I need to Stay in the Contract Until Expiration?If the stock rises from $18.81 to $25 and the option price is $6:The new cost basis for buying back the contract is $20.41 ($14.41 + $6).When owning the stock free of obligation, you could sell it for $25 and have a 23.7% return.$25 current price/$20.41 cost basis = 1.237 1 = 0.237.You would still have a loss ($4.40 - $6 = -$1.60) for buying back the call, but with the $5 intrinsic value .

19Do I need to Stay in the Contract Until Expiration?The intrinsic value of the stock will never hurt youre performance when buying back a call.Time value premium is what will effect youre performance if its higher than the premium you receive.If the call is in the money:The value of the position is the exercise price plus the cash received less any time premium you must pay to buy back the call.

20 Risk of Covered CallsThe covered call writer is exposed to all of the downside risk of the stock (less the premium received from the option).

They get hurt when the stocks price falls below the cost basis. This is why covered call writers should have a neutral or bullish outlook of the stock.

When combining to assets in a portfolio (such as shares plus short calls) that is the overall behavior of all assets that counts.21 Risk of Covered CallsMany professionals suggest that covered calls are risk-free. They affirm that the only risk with covered call is missing out large gains. However, the risk of any financial asset is never defined as missing out some reward. 22Writing In-the-Money CallsWhen selling an in-the-money call, you received more money than the intrinsic value youre sacrificing. For instance, if you buy a stock for $18.81 and sell a $15 call for $6.20, you are taking a loss $18.81- $15 = $3.81 worth of intrinsic value but are paid $6.20, which more than covers the loss. Writing in-the-money calls against your shares provides a greater cushion if the stock price should fall.In-The-Money calls are more expensive overall but they carry a smaller time premium which reduces the cost basis of the stock.They increase the downside hedge but provides lower returns.

23Which Expiration?All things being equal, investors are better off writing shorter-term contracts for the following reasons: They are exposed to a much more rapid pace of time decay (their value diminishes quickly). They are more expensive per unit of time.HoweverThere are some benefits in writing longer-term options:They provide more money and therefore provide a larger hedge if the stock should move against you.

24 Covered Call RationalWhy anybody would write a covered call since it limits your upside potential?Over time, covered calls will provide more stable returns and will provide higher returns most of the time. However, this does not mean that the covered call strategy produces higher return for less risk. This strategy can be a winning one for some stocks but it cannot always be the higher return strategy for the market overall .It can produce remarkable returns when it comes to investing steady and slow, specially when considering the compounding effects over time.25 Covered Call TrapInvestors unknowingly step into a trap if they believe that all covered call positions are conservative:

They dont realized the downside risk inherent with covered calls and inadvertently choose their covered call trades based on the volatility of the underlying stock.

An investor who is a beginner in the covered call strategy may hear that this is a conservative strategy. The untrained investor will choose to sell calls with the highest premiums when looking at options with the same moneyness across a variety of stocks. If you chose the call options with highest premiums you are choosing the most risky stocks. The investor end ups holding a volatile stock that undoes the postion.26 Covered Call TrapInvestors who seek out the options with the highest premiums and buy the stock for the sole reason of writing the calls are called premium seekers. This is a high risk way to use covered calls.

Dont be mislead into thinking that all covered call positions are conservative.

When writing call options in a conservative way you have to be sure you are buying a stock that you wouldnt mind holding anyway even if options were not available.27 Synthetic PositionsPut-call parity offers insight into any strategy. The synthetic formula is: S + P C = 0

Now, we can solve for a covered call: S C = -P

28Synthetic PositionsThe equation tell us that the combination of long stock and a short call is equal to a short put. In other words a covered call is the same mathematically as a naked put.Any broker will tell you that short puts are one of the riskiest strategies available. At the same time, they will tell you they will tell you that covered call is conservative in nature. Both statements cannot be correct. It depends on how they are used.Asking yourself if you would be comfortable selling the naked put as another way to find if a particular covered call is suitable for you .

29Hedging with Covered CallsWriting a contract per 100 shares maximizes the amount of cash generate for any given strike (and create the largest downsize hedge), but it also has its drawbacks:

If the stock makes a sudden move upwards, then your gains are restricted and regret will set in.

You can avoid regret by not writing a contract per 100 shares.30Hedging with Covered CallsHedging your position by writing fewer calls is a simple solution. If you are obligated to sell a limited amount of shares (you have less options contracts than shares), you can participate in upside gains above the strike price.

The tradeoff between writing fewer calls is that you dont get as much of the downside hedge since you received less money.31Will I get Assigned Early?When writing covered calls dont expect to get assigned early even if the stocks price is well above the strike price. With the covered call, you have a short call position, another trader somewhere has the long side of that trade . If its not in the immediate best interest to exercise the call then you should not expect to get assigned.

32Will I get Assigned Early?The better off you are (covered call writer) the worst off is the long call buyer. Since the long call buyer controls the right to buy the stock he will not likely exercise early.The buyer will likely wait for future appreciation. If you are writing longer term contracts you should not expect to get assigned until expiration. Also you should not expect to get assigned if a dividend is about to be paid. If the buyer exercises he or she loses all of the extrinsic time value in the call. 33How will I Know if Im Assigned (Called Out of a Stock)?If you are ever assigned on a call, youll be notified by your broker the following business day. But you should be careful at expiration and not assume that you will not be assigned just because the stock closed below the strike Friday. The reason is that many brokers allow exercise after the closing bell.

It is possible that after-hours news could propel the stock to new higher prices and you could get an assignment notice on Monday.34 Buy Write

Buy write is a special order that allows traders to enter into a covered call as a "package deal" to the market maker. With a buy-write you can send an order to "buy" the stock and simultaneously "write" (sell) the call, which can be executed "at market" or as a "limit order." Regardless of how the order is placed, any executed order results in a net debit (because the stock must always be more valuable than the call).

This is exactly the idea behind the net debit with buy-writes. When you enter a buy-write, youre telling the market maker that you don't care what price they charge you for the stock or what price you receive for your calls as long as it is executed for a price less than or equal to your net debit limit order.

35 Execution Risk The simultaneous execution of both positions through a buy-write order eliminates execution risk, which is the result of adverse price movements Incidentally, there is a mirror-image trade that allows the investor to simultaneously get out of a covered call, which is called an unwind. If you unwind a covered call, you will sell your stock and simultaneously buy back the call option.

As before, the reason for doing both transactions simultaneously is to prevent execution risk.36 Buy Write: Overwriting Investors can write calls against shares they have been holding in the account. This is usually called overwriting and generally leads to a conservative use of covered calls since the investor was obviously willing to assume the downside risk. The buy-write, however, is typically used as a one-time strategy for the sole purpose of writing the call, which is a speculative use of covered calls. The buy-writer's philosophy is usually (not always) to find a high premium option and then buy the stock and simultaneously write the call.37 Buy Write: Overwriting Buy-writes can be a cost-efficient way to continually enter into new trades. Regardless of whether you are comfortable in assuming the downside risk or not, the buy-write can add a little edge for those times when you wish to buy the stock and write the call in the same transaction.

38Roll-outAssume that AGIX is $68.00 at expiration and the January $65 call that you sold is trading for the $1.70 intrinsic value and April $65 call is trading for $3.70. You could buy back the January $65 call and simultaneously sell the April $65 call for a net credit of $2. In other words, you have rolled out to the following month. Effectively you sold another $65 call for $2, which again lowers the cost basis of your stock by the same amount. This strategy is used when the stock makes a significant upward move.39Roll-outRolling out or rolling up trades are collectively known as rolling trades. This allows investors to make another investment based on the same shares that are already in the account. If you don't want to let go of your shares, you can always execute a rolling trade. The important point is that you make your decision based on sound objectives rather than rolling up just because you don't want to see your stock taken away.

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Roll-downs

A roll-down is the reverse of a roll-up. With roll-downs, the investor buys back the existing strike but sells a lower strike call against the shares. Investors are often forced to do this when the stock price falls since the higher strike price may be trading for too low of a price to make it worthwhile. You will always reduce your potential selling price when you roll down.

Remember that the covered call strategy is a neutral to slightly bullish strategy. If the stock price is falling then you may be in the wrong trade and it's usually not the best idea to try to "write" your way out of the loss by selling lower strike calls. In most cases, you just end up digging a deeper hole.

But depending on your cost basis, it can be a viable trade so is worth understanding.41Covered Calls are Less RiskyThere are some studies that have shown where covered calls have produced superior returns to the market while reducing less downside risk, which seems to go against the premise of the risk-reward tradeoff. But these studies are considering shorter time periods when the markets are relatively flat and, in these times, covered calls will outperform the market. It's a myth that they will always outperform the market while reducing your risk, which is what these studies lead many to believe.42Covered Calls

Covered calls are a good to combine with other strategies.

Covered calls are created by selling calls in a 1:1 ratio against your long stock.

The covered call strategy is a neutral to slightly bullish in market forecast.

The risk of a covered call is that the stock price falls.

Covered calls are synthetically equivalent to naked puts.

If you wouldnt write a naked put on a particular stock then you shouldnt use a covered call either.43Covered Calls

Dont expect to get assigned (called out) of a covered call early. If you do, it actually helps the position since you receive the maximum reward early.

You can buy stock and sell calls simultaneously with a buy-write.

In the long run, covered calls are more conservative than long the stock.

44DisclaimerDISCLAIMER: THE DATA CONTAINED HEREIN IS BELIEVED TO BE RELIABLE BUT CANNOT BE GUARANTEED AS TO RELIABILITY, ACCURACY, OR COMPLETENESS; AND, AS SUCH ARE SUBJECT TO CHANGE WITHOUT NOTICE. WE WILL NOT BE RESPONSIBLE FOR ANYTHING, WHICH MAY RESULT FROM RELIANCE ON THIS DATA OR THE OPINIONS EXPRESSED HERE IN. DISCLOSURE OF RISK: THE RISK OF LOSS IN TRADING FUTURES, FOREX AND OPTIONS CAN BE SUBSTANTIAL; THEREFORE, ONLY GENUINE RISK FUNDS SHOULD BE USED. FUTURES, FOREX AND OPTIONS MAY NOT BE SUITABLE INVESTMENTS FOR ALL INDIVIDUALS, AND INDIVIDUALS SHOULD CAREFULLY CONSIDER THEIR FINANCIAL CONDITION IN DECIDING WHETHER TO TRADE. OPTION TRADERS SHOULD BE AWARE THAT THE EXERCISE OF A LONG OPTION WOULD RESULT IN A FUTURES OR FOREX POSITION.HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL, OR IS LIKELY TO, ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM, IN SPITE OF TRADING LOSSES, ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS, IN GENERAL, OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS. PS. In our opinion, we believe, it may be possible, that heavy smoking and drinking may be hazardous to your health. If you choose to smoke and drink while trading, The Delano Max Wealth Institute nor Dr. Scott Brown is liable for any damage it may cause. If you slip and fall on the ice, we're not liable for that either.