Covered Call
Description
Writing Covered Call is the most basic of income strategies, yet it is also highly effective
and can be used by novices and experts alike.
The concept is that in owning the stock, you then sell an Out of the Money call
option on a monthly basis as a means of collecting rent (or a dividend) while you
own the stock.
If the stock rises above the call strike, you will be exercised, and the stock will be
sold . but you make a profit anyway. (You are covered because you own the stock
in the first place.) If the stock remains static, then you?re better off because you col-
lected the call premium. If the stock falls, you have the cushion of the call premium
you collected.
On occasion, its attractive to sell an In the Money or At the Money call while you
already own the stock. In such cases, the premium you collect will he higher. as will
the likelihood of exercise, meaning you?ll end up delivering the stock at the strike
price of the sold call.
P/L Profile
Steps to Trading a Covered Call
1. Buy (or own) the stock.
2. Sell calls one or two strike prices out of the money (i.e., calls with strike
prices one or two strikes price higher than the stock).
if the stock is purchased smultaneously with writng the call contract, the
strategy is commonly referred to as a "buy-write".
Generally, only sell the calls on a monthly basis. In this way you will cap-
ture more in premiums over several months, provided you are not exer-
cised. Selling premium every month will net you more over a period of
time than selling premium a long way out. Remember that whenever you
are selling options premium time decay works in your favor. Time decay is
at its fastest rate in the last 20 trading days (i.e. the last month), so when
you sell option premiums, it is best to sell them with a month left, and do it
again the following month.
Remember that your maximum gain is capped when the stock reaches the
level of the call?s strike price.
If trading US. stocks and options you will be required to buy (or be long
in) 100 shares for every options contract that you sell.
Steps In
1 Some traders prefer to select stocks between $10.00 and $50.00, considering
that above $50.00, it would be expensive to buy the stock. Ultimately its
what you feel comfortable with.
2 Try to ensure that the trend is upward or rangebound and identify a clear
area of support.
Steps Out
1 if the stock closes above the strike at expiration, you will be exercised. You
will deLiver the stock at the strike price, while having profited from both
the option premium you received and the uplift in stock price to reach the
strike price. Exercise is automnatic.
2 If the stock remains below the strike but above your stop loss, let the call
expire worthless and keep the entire premium. If you like, you can then
write another call for the following month.
3 If the stock falls below your stop loss, then either sell the stock (if youre
approved for naked call writing) or reverse the entire position (the call will
be cheap to buy back).
Outlook
with a Covered Call, your outlook is neutral to bullish. You expect a steady
rise.
Example
XYZ is trading at $28.20 on February 25, 2006.
Buy the stock for $28.20.
Sell the March 30, 2006 strike call for $0.90.
You Pay Stock price - call premium
28.20 - 0.90 = 27.30
Maximum Risk Stock price - call premium
28.20 - 0.90 = 27.30
Maximum risk of $27.30 is 100% of your total cost
here
Maximum Reward Limited to the call premium received plus the call
strike less the stcck price paid
0.90 + 30.00 - 28.20 = 2.70
Breakeven Stock price - call premium received
28.20 - 0.90 = 27.30
Initial Cash Yield
(Also Cushion) 3.19%
Maximum Yield if Exercised 9.57% (if the stock reaches $30.00 at expiration).
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