This is most exciting strategy and is used by many experienced traders and traders that are new to options alike. This strategy simply means you sell calls on a certain stock that you own in equivalent number of contracts. You can also sell calls at the same time of purchasing the stock and is referred to as “buy-write”. We already know from our previous posts that call options render a right to the buyer and an obligation to the seller. Here, by selling the calls we are obligated to deliver the stock in the event it is exercised. That is where we are using our already purchased or freshly bought shares as collateral and in the process we are “covered” against the obligation arising from the sale of calls. This strategy is the most basic and widely used tool in options world that combines the flexibility of listed options against a security with stock ownership.
Let us look into a hypothetical example of selling a call option by using a real stock and its option. For example, consider a company called Las Vegas Sands Inc (LVS). This company owns and operates casinos in USA and China and is starting new ventures in Singapore and Bethlehem. LVS trades on New York Stock Exchange (NYSE) with a closing price of $32.01 as of 9-17-2010. It has options listed with one dollar incremental strike prices. Which means one can buy or sell calls and puts for various strike prices. This stock has just doubled in the past six-and-half months. It may continue its run and might reach new highs in the next several months. But, if you think this might take a breather and stay around that price for a while or could even drop a little and pullback, then it is a good idea to sell covered calls.
The sale of covered calls lets you keep the premium received in return for the obligation that you sell the shares to the call buyer at the agreed price before a certain date. The $34.00 October 2010 expiration calls have closed at $0.74 which means you will receive $74.00 for every 100 LVS shares you owned by selling Oct. 2010 $34 call.
Say that you own 500 shares of LVS with a purchase price of $32.00 and decided to sell covered call (at times it is referred to as writing covered calls. Don’t get confused writing just means selling, there is no literary skill involved here).
You can sell 5 calls. If you can recall that options have a time value and the premium decays with time and more so in the last few weeks even at a higher pace. This means whenever you want to sell calls go with the closest available expiration calls which would be the Oct. expiration in our example. Sell out-of-the money calls to maximize the returns. That would be $34.00 strike price.
As an owner of 500 LVS shares with an initial investment of 32 x 500 = $16000.00 you are entering into an option contract obligation by receiving 5 x100 x 0.74 = $370.00 to sell the stock at $34.00 before third Friday of October.
Now, what are the different outcomes possible by the third Friday of October?
Stock closes below $34.00 – you get to keep the shares and the $370.00 (a profit of little over 2.3% on the $16000.00 initial investment). You may sell covered calls again for the November expiration this time around generate the income again. Rinse and repeat.
Stock closes above $34.00 – you are obligated to sell the shares at $34.00 limiting your profit to ($34.00 - $32.00 + $0.74) x 100 x 5 = $1370.00 (a return of 8.5%).
Stock closes below your original buy price of $32.00 – you get to keep the shares and the $370.00 premium – gives a protection of $0.74 on each share and leaving you at a breakeven price of $31.26.
The chart below explains the scenarios discussed above.
Current price : $32.01 | ||
Price | Profit / loss | |
24.01 | ($3,636.25) | |
27.56 | ($1,851.72) | |
31.26 | $0.00 | |
31.29 | $16.21 | |
34.00 | $1,370.00 | |
35.03 | $1,370.00 | |
38.76 | $1,370.00 | |
42.5 | $1,370.00 | |
Please be aware that the potential risk of selling calls without owning the underlying stock is unlimited as you are obligated to sell the stock at agreed price once you sell the calls and in theory the price of the stock can go up infinitely.
One more thing to keep in mind when you are selling covered calls is be ready to part with the shares if the price of the stock goes above the strike price. Under that circumstances if you still want to keep the stock wither you can buy back the sold calls and keep the shares or buy back the shares again in the open market and potentially initiate another covered call.
That’s in detail what covered calls are about. If you have any questions about this strategy do email me or leave a comment and I will be happy to answer. Don’t forget to
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Happy learning and Good trading.
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