The Power of Covered Calls

MetaStock U - Week 1 - The The Naked Traders - The Power of Covered Calls - July 20, 2013
By: Chief Trader Bruce E. Dinger
 

Writing covered calls is a very powerful cash flow generating strategy for both individual investors and professionals. It is a straightforward strategy that allows you to collect a premium when you sell someone the right to purchase your stock. Typically, a covered call is executed with a one or two month timeframe, but this can vary depending upon the investor’s investment goal.

Covered Calls Defined:

• The ability to sell a call option on a security you own
• Give someone the right to buy your stock at an agreed price
• Typically done with a 1 - 3 month timeframe
• You may be obligated to sell your stock if certain price points are hit

Options Basics

There are two types of options; CALL and PUT. Covered calls involve the use of CALL options, but instead of buying calls, the focus will be on selling calls. When you sell a call option, someone has the right to buy your stock at a pre-determined price on or before a set date (expiration date).

When doing a covered call, we sell the right to another investor to buy the stock we own for a pre-determined price.

Covered Calls – A powerful cash flow strategy used to generate income on stocks we own. When entering a covered call, we are paid in advance by the markets. The other investor is someone we’ll never know or meet. It is like having someone write you a check for the opportunity to own your property.

Think of covered calls as a lease on a house. Suppose you find a house for sale for $300,000. You ask the owner if you can give him $10,000 right now for the right to buy his house sometime between now and the next six months. He agrees, and you give him a check for $10,000. In this example, the homeowner is like the “covered call writer”…he owns the house and is willing to sell his property for a fixed price ($300K) on or before an expiration date (6 months), and in exchange for giving the investor the right to buy his house sometime in the future at this fixed price, the investor pays him a premium ($10K). 

Let’s say the home goes up in value prior to the 6-month expiration date – and it increases in value to $350,000. The investor has the right now to buy the property for $300,000…why? Because he had paid a premium earlier that set the contract giving him the right to purchase the property for $300K. He just made $50K minus his initial investment of $10K. Not too bad.

The owner is OK with this deal too – because he originally wanted to sell it for $300K and he also took in an extra $10K for giving the investor the right to buy his property between the date of the contract and 6 months.

If the property value would have languished around $290K at expiration, chances are the investor would not have bought the property, but the homeowner would have still made $10K on the deal for just giving the investor the opportunity.

This is the basis of a covered call. Let’s bring it back to the stock market. Say you own a stock and are willing to sell it, but rather than sell it right away, you decide you want to generate some cash flow. You can sell a call option to an options market maker, which gives him the right to buy your stock in the future at a set price. In exchange for this contract, an options market maker will pay you a premium -- cash money.

If the stock goes up, the market maker will likely buy your stock at the set price (strike). If your stock stays flat or even pulls down a bit the market maker may not buy the stock and you would keep your stock AND the premium. Either way, you make a profit on the stock or on the option premium.

DETERMINE YOUR STRATEGY FOR WRITING COVERED CALLS

When selling a covered call, you can use it as a strategy to sell your stock or keep your stock and receive a monthly premium.

To help in timing the selling point of the call option, you will likely refer to technical analysis. These are covered in greater detail in the Mentorship Program or Advanced Technical Analysis.

If the goal is to keep your stock and generate cash flow each month, then the time to sell the call option is when the stock is just about to take a breath to the downside and drop in value.

Covered Calls in Action

As an example, let’s say you purchased 1,000 shares of stock ABC at $24.00 per share and now it is trading at $29.01. You see it made an attempt to rally to $30 but failed with the demonstrated exhaustive wick. You decide to write a covered call on the stock, allowing the market maker the right to purchase your stock at a higher price ($30) – as you choose the OCT 30 CALL. In our example, when you sell the OCT 30 CALL against your stock position, the market pays you $1.16 per share or $1.16 X 1000 for a total of $1,160.00 (minus commissions).

This money goes into your account immediately and can be taken out the next trading day to be used however you see fit. Keep in mind; the premium collected is yours to keep no matter what happens…this allows you to profit on the income from the CALL if the stock moves higher, sideways, or down*.

*In this example, if your stock trades below your chosen strike price of $30 on the OCT expiration date, chances are that you will keep your stock and have the ability to write another covered call for the next available month. Covered Calls are a true cash flow generator.

Simple 7 Step Process

Step 1: Identify Optionable Stocks in Your Portfolio

Step 2: Determine the Market Forecast

Step 3: Check the Options Chain

Step 4: Calculate the Numbers

Step 5: Sell the Call Options

Step 6: Monitor the Position

Step 7: Close Out the Trade if Necessary

Risks

• There is a chance of selling your stock – so be willing to sell it
• You give up the opportunity to profit if the stock rises above your chosen strike price (the price you agreed to sell it for)

Advantages

• Allows you to generate monthly cash flow from stocks you own
• Serves as downside protection in the event the stock drops in value
• It can be a growth or income strategy

About Bruce E. Dinger

Chief Trader Bruce E. Dinger, CEO and Chief Trader of TNT Trading the Stock Market, formed the The Naked Traders with the concept of teaching other independent traders how to "strip themselves of all emotion" when they trade or invest in the stock market.

Mr. Dinger has spoken on some of the largest stages around the globe, including CNBC, BusinessWeek, SuccessMagazine, The Women's Financial Conference, Rich Dad's, On-Line Trading Academy, Success Resources, and many others. He has one of the best reputations in the financial markets for helping students achieve their goal of becoming an independent trader or investor. Mr. Dinger can be reached at info@TheNakedTraders.com.