"Covered Call" writing has become a popular way of increasing cash flow while providing downside price protection on the underlying stock.This type of investment is generally used for income and is used a market neutral to bullish framework. Many investors maintain the viewpoint that options are "too risky" and "too complicated" for them to use. Buying options are risky, however, covered call writing (selling options on stock you own) is considered a very conservative way of increasing your portfolios cash flow and is allowed by the U.S. Government for IRA accounts. A person owning common stock in many of the companies trading on the major exchanges, may sell (write) a call option at any time, which gives the purchaser the right to buy your stock at a certain price (Strike price) by a certain date (Expiration month). Stock options sometimes contain real value and almost always contain a premium, whereby the "premiums" are dependent on many factors, such as the volatility of the stock itself, the strike price and the expiration date of the option.

 

The closer the "strike price" is to the price of the stock, the more money you will receive for the sale of the option. If the strike price is below the stock price, the option will contain real value and some premium. Whereas, if the strike price is above the stock price, the option price will be all premium. Whatever the strike price is, the further out in time the expiration date is, the higher the option price will be and thus you will receive more money for the option. A comparison of the various option prices and resulting return on investment, as well as the "loss protection" must be completed for you to determine which alternative is best suited for you. Sometimes the premiums are higher (relative to the time value), for a nearer term option than options sold many months in the future. For example, you may be able to make a 20% yield selling a September option, and 25% yield for selling a December option. Since you only make an additional 5% for waiting another three months, in most cases it would be more advantageous to sell the September option.

 

If you purchase 100 shares of XYZ Incorporated for $25.40, you would sell (write) one option contract (1 contract = 100 shares). If you purchased 300 shares, you would sell (write) 3 contracts.

 

The following is an example of a covered call transaction, where the investor purchases a stock for $25.40 per share and sells an option with a strike price of $25.00, with an expiration date three months away in September. This is called an "In The Money" covered call, because the option strike price is below the stock price. In the money calls are the most conservative options to do, however, the percent returns are somewhat lower than with strike prices above the stock price.

 

The following is an example of a covered call transaction, where the investor purchases a stock for $25.40 per share and sells an option with a strike price of $25.00, with an expiration date three months away in September. This is called an "In The Money" covered call, because the option strike price is below the stock price. In the money calls are the most conservative options to do, however, the percent returns are somewhat lower than with strike prices above the stock price.

 

---

 

"COVERED CALL" TRANSACTION EXAMPLE

Company	XYZ Industries
Stock Symbol	XYZ
Stock Price	$25.40 per share
Purchase	200 shares
		Price Per Share	Total Cost (in USD)
Step 1: Investor buys 200 shares of XYZ stock		$25.40	$5080
Step 2: Investor sells a particular option Example: sell September 25's (symbol XYZIF)		$6.25	$1250
		==============	==============
Your Net Investment		$19.15	$3830
Expiration Date (if your stock is over $25.00 on September 22nd)		$25.00	$5000
		==============	==============
Your Profit		$5.85	$1170
Return on Investment (Actual): 30.5%
Return on Investment (Annualized): 66.5%

At any time prior to the "expiration date" of the option, or prior to someone exercising their right to buy your stock, you may buy-back your recently sold option at the current market price. Once you buy back your option, your obligation to sell your stock is terminated.

If by the expiration date, the stock is under the strike price of $25, let us assume $22.50, your stock will not be purchased for the $25 option price because the holder of your option can buy the stock for $22.50 in the market. Therefore, you keep your shares and may either: (1) sell your stock for $22.50 at the market, or (2) sell another option several months forward for more cash. Since your cost basis is now $19.15, selling another option would probably bring your investment cost basis down to approximately the $14 to $15 per share range.

 

---

 

SUMMARY

This illustration shows an example of selling an "In-the-Money" call option that yields a good return, while protecting your asset down to $19.15, which is 25% less than your purchase price. However, if the stock price increases to $35.00, you will only receive $25 since you sold an option with a $25 strike price. Selling covered calls is always a trade-off between the potential return on investment and the amount of safety you obtain from selling the option. Since selling calls will limit your upside growth potential, this adds another element to the "trade-off" decision.

OptionScanner.com provides its' subscribers with tables for each stock designed to evaluate these choices.