Covered Call Writing II
July 28, 2010

Covered Call Writing II

Investment club members are usually conservative investors.  They carefully choose stocks to buy and plan to hold investments for an extended period of time.  If the company continues to grow, the value of the stock should increase accordingly.  Thus, it's reasonable to ask: 'We just bought this stock, so why would we want to enter into a contract to sell those shares?'

Trading and investing involves subtle psychological factors that most people ignore.  If you can understand them and get over them - if you recognize that a $400 profit is a $400 profit, then covered call writing makes more sense.  Here's an example.

Let's assume you spend $2,000 to buy $100 shares of stock.  Note, it doesn't matter if you buy these shares in a single transaction, or whether you bought the shares piecemeal, over an extended time.  Your club owns the 100 shares and the current price is $20.

The prospects of this investment excite you. Your group anticipates being able to earn 15% per year by holding this position, and that's a very good return.  Putting that into numbers, one year from today, you hope to see the stock trading near $23 per share.  We all know markets more higher and lower, so your expectation is more likely to be a price range than the specific price of $23.

Suppose you consider selling a call option.  It expires in approximately one year and has a strike price of $20.  You can collect $400 for that option.  If you sell it, two things can happen. 

At the end of the year, if your stock is trading at less than $20 per share, the option expires worthless and your cost basis has been reduced from $2,000 to $1,600.  That's a very good result - especially when the stock has not performed as expected.

At the end of one year, the stock is higher than $20.  The owner of your call option exercises his/her rights to buy the stock at $20 per share.  You earned $400, or 20%.  This exceeds your target of %15.
Both of these results are good.  It is possible that the result is not the 'best possible.'  If the stock is above $24, then you earned less than the maximum possible return.  But look what you received in exchange:  You are ahead of the game any time the stock rises but is below $24.  You get $400 cash any time the stock declines in price.  For a stock that you want to hold and you want as part of your portfolio, there are only two possible results when writing the option:  You cut your cost by $400 (25%) or you earn a $20% profit in one year.

Those are two excellent results.

Writing covered calls is an investment alternative that is worth considering - for any club that owns 100 shares or more of any stock that has listed options (they trade on an exchange). Does it really make any difference whether you earn a profit form an increase in the stock price or whether you earn that same profit when selling calls? 

Mark D Wolfinger

Expiring Monthly: The Option Traders Journal

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