The Deal
The following paragraphs will explain the basics of making money by writing covered calls. Since this section is quite lengthy, you may want to print it using your browser's print utility so that you will have it as a handy reference. With that in mind, we will keep the hyper-links to a minimum. We also provide a page with suggested books and other resources that can be accessed from the menu to the left. Terms that may be unfamiliar to non-traders will be explained as we go along.
Let's do a sample deal. This sample will be done using a "margin" account. A margin account with your broker lets you purchase stock with one half of the purchase price of the stock. The broker loans you one half of the purchase price. We will discuss broker commissions and margin charges later.
Because this is a "covered" call deal, we need to own some stock. Using actual prices, let's buy 500 shares of Krispy Kreme Doughnuts. All stock is tracked in the stock market by its ticker symbol. The symbol for Krispy Kreme is KKD. On January 23, 2006, KKD was selling for $5.00 per share. Our cash required is $5.00 times 500 divided by 2 = $1,250.
Now that we own some stock, we are able to sell calls to someone that wishes the right to buy it from us sometime in the future. Our best deals will usually be on calls for the next month, so we look at all the February calls for KKD. We will be looking at calls that have a future selling price for the stock, or strike price, that is close to the price that we just paid for that stock. We find that the price that someone is willing to pay for a KKD February call with a strike price of $5.00 is $0.30. Calls also have ticker symbols and this one is KKDBA. Option contracts are written on blocks of 100 shares of stock. We therefore are able to sell 5 contracts against our 500 shares of stock. Since we are being paid $0.30 per share we will receive $150.00.
We just got a return of $150 on the stock that we purchased for $1,250. Simple arithmetic of 150 divided by 1250 gives us a yield of 12% on our investment. That is about the return we should expect, right? Everyone says that stocks average about 10% per year. But wait, this all happened in one day. Could this be a daily yield of 12%? No, of course not. Remember that we have sold someone else the right to buy our stock at $5.00 per share at some future point. That future point has to be before the expiration date of the option. Since options expire on the third Saturday of the month and this is a February call, it will expire on February 18, 2006. We will have to leave our money tied up in the stock until then in case whoever bought the option wishes to "exercise" it and buy our stock. This is, therefore, a monthly deal with a monthly yield of 12% and a yearly yield of 144% without any compounding. Do we have your attention yet?
What really happens at expiration? There are two possiblities. If the price of the stock is above $5.00, the buyer of the option will probably "call you out" and purchase the stock. You will have $1,400 ($1,250 + $150.00) in your account instead of $1,250. If the price of the stock is $5.00 or lower, the buyer of the option will let it expire since he could just go buy the stock cheaper on the open market. You will have $150 in your account and still own 500 shares of KKD. You can sell another option on the stock, sell the stock, or keep it for your portfolio.
The above example was based on selling an option with a strike price the exact same price as we paid for the stock. That is called an "at the money" call. We will now do the same deal as an "out of the money" call. Everything remains the same except that we are able to buy the stock for less than the strike price, $4.80, for example, instead of $5.00. We will pay $1,200 for the stock. Remember, we are buying on margin. We sell the February $5.00 call for $150 as before. Our yield (150 / 1200 = 0.125) raises to 12.5%. At expiration, if the stock price is above $5.00 and we get called out, we realize a further gain from the sale of the stock. The buyer pays us $5.00 per share for a total of $2,500. We pay the broker back the $1,200 that he loaned us and have $1,450 (1,300 + 150) in our account for a yield of 20.83% (250 / 1200 = .2083) for one month. If the price at expiration is $5.00 or below, this works just like an at the money call.
Just to temper your enthusiasm, we will look at an "in the money call." Everything is the same except that we pay $5.20 for the stock. We will pay $1,300 for the stock. We sell the February $5.00 call for $150 as before. Our yield (150 / 1,300 = .1154) is now 11.54%. If we get called out at expiration, we will receive (2,500 - 1,300) $1,200. We will have $1,350 in our account for a yield (50 / 1,300 = .0385) of 3.85% for the month. And we will be crying the blues because we only made (3.85 X 12) 46.15% for the year. Double Digit Deals are awesome!
There has to be a catch! What if the stock is at $4.25 on expiration day and no one wants to buy its options? That would be a 15% correction in the market. Sell the stock and find the next deal. If you do 15% for the next two months, you have regained the loss and are on your way again. Remember that half the stock you owned was on margin so you have to make up that loss also. A 30% market crash would take less than 6 months to recover.
You actually would back out of the deal before the expiration date in a case like this. We will cover the mechanics of doing that in the section titled, "How do I handle the stock price going down?" under the FAQs menu
Market crashes are one thing but all these deals can't be winners. That is true and is why you want to do several deals each month. The 30% out of the money deals help smooth out the break-even deals and the losers. Obviously, you will need to do fundamental research on the companies and try to choose ones that have good prospects. See the Books menu for books that show how to analyze the fundamentals of companies. The high option prices that make these deals work mean that lots of investors think that the price of the stock is going up. Why else would they pay you for the option? Thus, there is sort of a built in filter in the deals we look at. Real world experience from our own accounts and those of traders using Sage Investors Inc. data show 15-18% yields. Even in a bear market, there are lots of stocks that gain value. You just have to be even more careful when researching the companies.
Don't do this with money you need to live on! Don't do these deals as your only investment strategy. Make sure you do several different deals each month so that all your money is not tied up in one stock. Do your homework. One of the reasons that we developed this service was to enable us to spend less time combing the papers for deals and more time researching the top deals.
The details and mechanics of trading are covered in the Frequently Asked Questions (FAQs) available from the menu to the left. We also strongly urge you to use the many resources available to you in print and on the internet to learn about the stock market before you risk your money. The rewards are substantial for the informed and intelligent trader.
By the way: On February 17 (the last day to trade before expiration) KKD was selling for $6.85 so we got called out. Total commisions and margin interest that had to be paid to our discount broker were just under $52 so our actual yield was 7.84%. This was a very conservative deal on a stock trading at the bottom of its range.
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