Covered Call Writing. A Real World Example

Covered Call Writing

A Real World Example


If your club has given some thought to using options, but has not yet taken the plunge, this article may provide an impetus to begin.  We'll take a look at covered call writing, a conservative strategy - one that enhances returns and provides some insurance against loss if the market declines.


In my experience, the largest hurdle for investors to overcome when writing covered call options is the realization that they must accept a maximum profit from stocks they own.  Investors dream of owning stocks that double again and again - but the truth is, these stocks are difficult to find.  Unless you have a proven track record of doing so, it's best to face reality and look for more modest returns.  Studies show that most individual investors, as well as most professionals (mutual fund managers) - cannot consistently earn a better return than the market averages.  When writing covered calls, your portfolio is not only less volatile (less subject to wild ups and downs in its value), but it has an increased chance of outperforming the market (Data is available to support this statement).   But to play the game of covered call writing, it's necessary to accept the fact that your profit potential is limited (but sill substantial).


   Using Apple Computer as an example, not a recommendation, we see that last Friday (Aug 5, 2005) Apple Computer (AAPL) closed at $42.99.  For the buy and hold investor to earn a return of 20 percent, the stock must increase in value to 51.59 within the next 12 months.  If your club owns this stock, you must decide if this is a likely scenario and if you consider this the best way to achieve that 20 percent profit target. 


   Another investment method to help you achieve that 20% growth rate is to write (sell) covered call options.  Keep in mind that you must own at least 100 shares before you can write a covered call option and that commissions can be costly - unless you use a deep discount broker.


   Here's how it works.  On Monday, Aug 8, write the Sep 42.5 call option (sell one call for each 100 shares of stock you own).  By doing so, you accept the temporary (until the option expires on the 3rd Friday of Sep) obligation to sell your AAPL stock at $42.50 per share - if the option owner elects to buy your stock.  If the market opens unchanged, you should be able to receive $2.10 for your call option.  That $210 is yours to keep, reducing your cost of your shares by 2.10 per share.


    There are two possible outcomes when expiration day arrives.  Either the option owner chooses to buy your stock (if that happens, you must sell), paying $42.50 per share, or the option expires worthless, relieving you of your obligation to sell your shares.


For simplicity, let's assume you bought your shares at $42.99 and collected the call premium of $2.10.  That means your shares cost $40.89 each.  If the stock is above 42.5 (the strike price) when expiration day arrives in 6 weeks, you receive $4,250 for 100 shares of stock. That's a get gain of $161, representing a return of 3.9 percent for 6-weeks.  If you were able to earn that amount every 6 weeks for an entire year, you would earn over 30% on your investment.  Does that sound attractive?  Is this something you club wants to consider?


   If expiration arrives and the stock is below the strike price, the option owner will not elect to buy your shares.  The option expires and you are free to write another call option, and collect another cash premium, the following month.  You can do this month after month.  The amount you can collect when selling the call option will be different every month and depends on many factors. .  If AAPL declines in price, call buyers will not be willing to pay as much for calls with a strike price of 42.5 and you may have to settle for less than the $210 available this time.   You cannot know future option prices in advance, so it is impossible to know what your future returns will be. .


   If the stock drops significantly, you may not be happy with the lower stock price, but you will be better off than if you did nothing.  After all, that $210 call premium you received puts you $210 ahead of the buy and hold investor. It's also possible that the stock might stage a strong rally.  If AAPL rises to $50, you would have made more money by not writing the option..  Since you cannot foresee the future, you must determine which approach gives you the better chance of earning a good profit from your stock.  There is no 'right' answer.  Each investment club must determine an appropriate investment strategy for itself.


   Writing covered calls requires a small amount of effort:  Your club must choose which option to write.  You must decide whether to write options that expire every month (as in this example), or less often (every 3 or 6, or even 12 months).  You must determine if your commissions are too high to make this a worthwhile strategy and whether to consider changing to a deep discount broker.  But, if you do decide that writing covered calls is worthwhile, you increase the likelihood that your club will be profitable - and if it's a down year for the market, your losses (if any) will be reduced by the amount of option premium you collect.


   Keep in mind that it's okay to start small.  Choose one of your holdings for a covered call writing program.  If your club members enjoy this strategy and if it is working for you, you can consider rounding out all of your holdings (to increments of 100 shares) so you can write call options against each.


   Best of luck with your adventures in covered call writing.


Mark D. Wolfinger