Monthly Income with Options - Write Covered Calls
Writing Covered Calls
http://www.option-trading-guide.com/coveredcalls.html
From looking at Straddles, which thrive on volatility, we now take a look at a strategy
that's much more conservative. It's so conservative that some retirement funds allow this strategy in their portfolio.
Writing Covered Calls are a "moderate" investor's favourite strategy. It works particularly
well when the stock in question doesn't move dramatically up or down, but rather just trends sideways.
Basically, it works for stocks that are deemed too "boring" for option plays.
to the act of selling stock options. So when we write covered calls, we are actually selling a call
option.
To recap, buying a call option gives you the right, but not the obligation, to buy a stock at a specified price at a specified date. Conversely, if you sell a call option, you now have the obligation to sell the stock to the option buyer at the agreed upon price at the specified date.
Taking a look at our housing example earlier on, the owner of the house basically wrote
/ sold an option to us by promising to sell us the house at the agreed price. We could
decide whether we wanted to buy the house, but if we did want to buy it, the house owner
is required to sell it. He does not have the luxury of saying no.
So a Call Writer is agreeing to the obligation to sell stock, while a Put Writer is agreeing to the obligation to buy stock.
Scary isn't it? Who would want to enter a contract with such obligations?
The good part is, when you sell an option, you receive the Premium of the option.
Which means you instantly make money from a transaction.
In that case, why doesn't everyone start selling options?
Let's take a closer look at selling Call options.
To recap: when you buy an option, you buy the option to Open a Position, and
sell it later on to Close the Position. Similarly, when you Write options, you write
the option to Open the Position, and you must Close the Position somehow,
whether it's by letting the option expire worthless, or by buying the option back.
In the case of selling Call options, remember that Call options are more In-The-Money the
higher the stock price goes. So if you sell a Call option and the underlying stock price
goes down below the option's strike price (meaning the option becomes Out-Of-The-Money),
the option will expire worthless. You therefore don't need to do a thing, and can pocket the
profit you earned by selling the option.
However, the danger happens when the stock price keeps climbing. If it keeps going up,
it will never become worthless, and come expiration day, someone is going to exercise the option
and buy the stock from you. You have been Called Out.
The problem is, you don't own the stock! You would need to buy the stock at the current
market price (which has gone up), and sell the stock to the option buyer at the previously
agreed strike price, which would have been lower. This would cost you a lot!
Let's take a look at a numerical example:
Say the price of stock ABC is now sitting at $18. You sell a Call option for a strike
price of $20, expecting the stock to hover around the $18 level. Let's say you earned
$1.00 on the option premium (which is $2 Out-Of-The-Money).
Scenario 1: If by expiration day the stock price ends up at $19, which is below the strike price of $20, you're fine, since the option is Out-Of-The-Money and will expire worthless.
Scenario 2: What if by expiration day the stock price jumps to $26? The option is now
In-The-Money by $6, and you have been Called Out. So you will need to buy the stock
at the current market value of $26, then sell it to the option buyer at $20. That's a loss
of $6 for you, and if you include the $1.00 you made earlier, still results in a nett
loss of $5.00.
Let's look at this in tabular format:
| ABC | Scenario 1 | Scenario 2 |
| Premium Earned | $1.00 | $1.00 |
| Strike Price | $20 | $20 |
| Final Stock Price | $19 | $26 |
| In-The-Money? | Out $1 | In $26 |
| Cost of Stock Purchase | --- | $26 |
| Earnings from Stock Sale | --- | $20 |
| Total Profit | $1.00 | - $5.00 |
In order to lessen that risk, what we can do is to actually buy the underlying stock
the same time we sell the option. For example, if you want to sell 1 contract of ABC options,
you would buy 100 shares of the ABC stock at the same time (remember that 1 option contract
is equivalent to 100 underlying shares).
By buying the shares, we eliminate the risk of having to buy the shares later at a higher price in case we get called out. This is called covering your call writing, ie. we just wrote a Covered Call.
Let's return to our numerical example, but this time we write covered calls on it. Previously, we
sold a $20 Call option for a premium of $1.00 when the stock was currently at $18. This time, we also bought 100 shares of the stock at $18.
Let's look at 2 scenarios, one where the stock went down in price, and another where the
stock climbs above the option strike price.
Scenario 1: If the stock price falls to $17 by expiration day, the option expires worthless and we are not called out. We lost $1.00 because we bought the stock at $18 and it's now at $17. However, since we previously sold the option for $1, we actually broke even. And we still own the stock.
Compare this with just a simple purchase of the stock. When we write covered calls, ie. selling
an option together with buying the stock, we actually increase our loss tolerance by the option's premium amount. In this example, we increased out loss tolerance by the option premium of $1, meaning we could afford to have the stock drop $1 without actually losing anything.
That is our break even level. As long as the stock price stays above that level, we profit. Anything less and we lose. That's why we need to look at stable or moderately bullish stocks to consider for writing covered calls.
This is important in the stock market, where stocks we buy usually don't go up the way
we expect them to...
Scenario 2: If by expiration day, the stock goes up to say $26, we would be called
out. However, there is no risk, because we already own the stock, and can just sell it immediately.
However, since we already agreed to sell the stock at $20, that is the price we have to honor. So we sold the stock at $20. In total, we earned $2 from selling the stock ($20 minus the $18 we spent earlier), and earned another $1 from selling stock options
earlier on. That's a total $3 profit.
Let's look at this in tabular format:
| ABC | Scenario 1 | Scenario 2 |
| Cost of Stock | $18.00 | $18.00 |
| Premium Earned | $1.00 | $1.00 |
| Strike Price | $20 | $20 |
| Final Stock Price | $17 | $26 |
| In-The-Money? | Out $3 | In $26 |
| Earnings from Stock Sale | --- | $20 |
| Change in Value of Held Stock | -$1.00 | --- |
| Still Keep the Stock? | Yes | No |
| Total Profit | $0.00 | $3.00 |
Now let's take a look again at Scenario 1. The Call option has expired worthless, and we keep the stock. This means that month after month we can keep selling stock options on those 100 shares we own, and as long as we don't get called out, we can make constant monthly income! And what if we get called out? As Scenario 2 shows, getting called out still earns us a profit!
This is how investors write covered calls to generate a monthly income. This strategy usually earns about 3% to 15% a month. Not bad for a strategy that's almost risk-free!
However, do note that if you are unlucky enough to choose to buy a stock that keeps falling
lower and lower, no strategy is going to help you! (Unless you buy a Put option on that
stock to reduce your losses).
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Sell Stock Options Safely For Monthly Income
http://www.theoptionclub.com/vertical_option_credit_spread.html
Options can also be used in ways that produce profits on a consistent basis.
All option contracts expire. This is a certainty. In fact, not only do we know that they will expire but we also know precisely when they will expire. The only question we cannot answer ahead of time is whether the underlying stock price will be above or below the options strike price.
The strike price is that price at which, in the case of a call option, the option holder may purchase or, in the case of a put option, sell the underlying stock. If you own a call option, you would have the ability to buy the stock at the strike price. If the stock is trading at a price level higher than the strike price your call option will allow you to purchase the stock at the lower strike price.
What this also means is that if you sold that same call option, your option would expire worthless so long as the stock price remains below the level of the strike price.
Conversely, a put option allows the buyer of that option to sell the underlying stock at the strike price, so if you sell a put option, your option will expire worthless so long as the stock price is above the level.
When you sell an option, you receive a cash payment to your account. You remain obligated to perform upon that short option until such time as it expires or you close the contract by repurchasing it. Because options expire on a known date, if you are able to identify a where a stock is likely to trade, or where it is not likely to trade, it may then be possible to sell call options above that range or put options below that range.
If you are correct in your assessment of the market, those options will expire worthless and you can keep the entirety of the premium that was paid into your account without further obligation.
Selling options is not without its risks, but there are methods of curtailing those risks significantly.
One of the more favorite tools of sophisticated options sellers is the vertical credit spread. This involves that simultaneous purchase and sale of two options. The technique allows the option seller to still capture premium, but a cheaper option is purchased to limit the maximum risk. It is possible to limit your risk to less than $100 per trade.
Monthly premium income can be created in a safe, reliable manner by identifying key areas of support and resistance in the market. Selling stock options using a limited risk strategy, such as the vertical credit spread, preserves the high probability of success while also limiting the risk involved in an unexpected market move.
To learn more about vertical credit spreads, visit TheOptionClub.com and register for their free stock option trading lessons and newsletter.
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Relationship between Stock/Security and Options
The premium, is the amount you receive when you sell an option, or conversely, the amount one would pay to buy an option.
For example, XYZ is trading at $50 per share and the XYZ October 50 call is trading at $5.00 per share. The $5.00 per share cost for the XYZ October 50 call option is referred to as the premium.
The premium reflects the risk in the underlying security. Risk being defined in terms of volatility, which simply quantifies how dramatically the underlying security can move up or down from its current price level. Without belaboring the point, the more volatile the underlying security, the higher the option premium.
Knowing that options and risk are inexorably linked, we come back to our original thesis; how much income does your hypothetical $100,000 nest-egg need to produce?
We’ll begin by purchasing 1,438 shares of the Canadian Imperial Bank of Commerce (symbol CM, listed on the TSX) at $69.50 per share.
At the same time, we’ll sell 14 CM January (2006) 70 calls at $3.20 per share. These call options obligate you to deliver 1,400 of your 1,438 shares at $70 per share to the call buyer anytime between now and January 2006. If the stock is called away at $70 per share, you receive $98,000 plus you will still own 38 shares worth at least $70 per share ($2,660 total value fort the additional 38 shares) for the for a total portfolio value of $100,660 ($98,000 for the shares that were called away plus $2,660 for the shares that did not have options written against them).
Here’s where comfort comes into play. You need to ask how comfortable are you that CIBC will be worth at least $70 per share 11 months from now. If you are comfortable with CIBC, the next step is to look at what kind of income you can generate with this strategy.
First of all, you have the call option premium that can be paid out over the next eleven months. You received $3.20 per share in premium income multiplied by 1,400 shares for a total value of $4,480. The option premium income is taxed as a capital gain if it is earned outside an RRSP.
You will also receive three dividend payments over the life of this position. CIBC pays 65 cents per share in quarterly dividends which works out to $1.95 per share in total dividends received over the next 11 months. Based on the 1438 shares purchased, you will receive an additional $2,804 in dividend income. The total cash flow from this position over the next 11 months is $4,480 in capital gains income plus $2,804 in dividend income for a total income of $7,284 (that represents a monthly income of $662). This is what could be paid out over the next 11 months without impinging principal. Assuming, of course, CIBC is above $your $69.50 purchase price in January 2006, and assuming that CIBC maintains its’ current dividend.
Having vetted the risks, we’ve now come full circle. The initial objective was $8,000 per year or $666.67 per month, in pre-tax income. With the CIBC covered call write example, about two thirds of the cash flow is capital gains (the option premium), the remaining one third being dividends. Over the next 11 months, you would draw income at a rate of $662 per month, just slightly below your goal.
The worst case scenario would see the value of CIBC shares decline below $69.50 per share. In this case, you retain the shares but may not be able to capture enough premium income to satisfy your needs for the next year. And we define the risk by asking the question; how comfortable are you the worst case scenario?
Of course this was meant as an example of an alternative source of income. In reality, you would want to hold a number of dividend paying stocks to provide the portfolio with some reasonable diversification.
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