Introduction To Covered Call Writing
Being a member of an investment club is fun. You have an opportunity to expand your investing knowledge, gain experience managing investment dollars, and earn some money.

Traditionally, most successful investment clubs adopted a buy-and-hold investment philosophy and carefully chose stocks to buy. The objective was to earn money as those companies grew and prospered over the years. Some clubs were less disciplined and tried to profit by chasing hot' stocks. There are many ways to manage a club's investment portfolio and in today's world, sophisticated clubs are adopting modern investing methods.

The purpose of this, the inaugural Know Your Options column, is to describe how your club can adopt one of the more sophisticated yet simple to learn and use strategies. It's called covered call writing and is a conservative strategy using stock options. The strategy is very appropriate for investment clubs and is widely used by individual investors.

Brief Description Of Covered Call Writing In Layman's Terms:

Your club enters into a contract that is valid for a limited, but agreed upon, period of time. Your club sells the right to buy 100 shares of a specified stock at a mutually agreed upon price. The other party to the contract pays your club a cash premium. That cash is not a down payment, but is yours to keep no matter what else happens. Note: The other party is not obligated to buy your stock, but merely has the right to do so. You must sell your stock if and when the other party chooses to buy as long as you are notified before the contact expires.

There are 2 possible outcomes to this contract::

  • You sell your stock and receive the agreed upon price. You also keep the premium received earlier.
  • If you don't sell your stock
    • The agreement is no longer valid and you are under no further obligation to sell stock
    • Your club continues to own the shares and keeps the cash premium

Note: Both outcomes are good for your club. If you don't sell the shares, you are ahead by the cash premium you received. If you do sell, the sale occurs at your price and you keep the cash premium as a bonus.

The contract described above is a call option. The buyer of a call option has the right to buy 100 shares of a specified stock at a specified price (called the strike price) for a specified period of time. The price the option buyer pays to the option seller is called the premium.

Comparing Strategies

Let's assume you have enormous confidence in your club and it's membership, and your goal is to earn 20 percent per year on your investments. That's almost double the rate of return produced by the American stock market in the past - but you believe you can accomplish this goal nonetheless.

Let's look at one of your holdings, XYZ trading at $50 per share, and consider two different ways in which you can achieve your target profit. Then you decide which method gives you the better chance of achieving your goals.

  1. Buy and hold strategy. To earn 20 percent per year (compounded), XYZ must be at least $60 after one year and at least $72 after 2 years.

  2. Covered call writing strategy. There are many possible scenarios, but here is one: You sell a call option that expires in 6 months. The strike price is 55 (the price at which the option owner has the right to buy your stock) and you are paid a premium of $3 per share, or $300 per option contract.

    After 6 months, there are two possibilities.

    1. If the stock is above 55, the option owner elects to buy your stock at $55 per share. Because you collected a $3 per share premium, your total selling price is $58. That represents a return of 16 percent ($800 profit on a $5,000 investment) in 6 months exceeding your objective.

    2. If the stock is below $55, the option owner allows the option to expire worthless. You keep the $300 and the stock. You have not made enough to meet your target, but you earned $300 (6 percent return) more than you would have earned with the buy and hold strategy.

Conclusions: When using covered call writing

  • You have a much better chance of earning your 20 percent target

    • If you collect a $300 premium twice in one year, that represents a 12 percent return. Your stock only has to reach 54 (for an additional 8 percent profit) to earn that 20 percent. With buy and hold, the stock must climb all the way to 60. Clearly XYZ is much more likely to be 54 or higher at year-end than 60 or higher.

    • Your probability of losing money on your investment is reduced

  • You have a $300 cushion in case the stock declines in price

What's the Cost of Adopting Covered Call Writing?

This strategy enhances profits and reduces losses most of the time. But you must give up the chance of earning a bonanza on your stock. No matter how high the stock rises, you are obligated to sell your shares at the strike price. Thus, if your goal is to own stocks that double again and again, covered call writing is not for you.

Thus, the question: Is your club much better at stock selection than everyone else? Can you consistently find the next great growth company, such as Microsoft or Wal-Mart? Do you want to attempt to find those companies? Do you prefer not to limit the selling price of your shares? Or, do you prefer to use a method that increases your chances of outperforming the market on a consistent basis? If your objective in joining an investment club is to learn how to become a successful investor, then you owe it to yourself to investigate covered call writing. It's not for everyone, but is it for you and your club?

Next time we'll take a detailed look at real world examples of Covered Call Writing.