Friday, March 20, 2015

How to Boost Your Stock Market Returns With Covered Calls

In this article, we will discuss covered call writing, and how it can boost your stock market return.
A call option is a contract to buy 100 shares of a particular stock, at a certain price (called the strike price), by an expiration date. The buyer of the call option pays a premium, and this is the maximum he can lose. If the stock goes up enough in value by expiration, then the buyer may make money.


The seller (or writer) of the call, on the other hand, pockets the premium, and this is the most he can gain. He hopes that, at expiration, the price of the stock is at or below the call's strike price. Then, the option expires worthless. If the stock ends up trading above the strike price, then the call writer needs to deliver 100 shares of stock.
If the call writer does not own the stock, he has to buy it on the open market. This subjects him to the possibility of an open-ended loss. For example, let's say that IBM is trading at $ 157 per share and a call writer sells a September 165 call for $ 1.35. The writer than pockets $ 135 (since options trade in units of 100). If, at the option's expiration, IBM is trading at $ 168, then the writer has to sell 100 shares of IBM for $ 165. Since he has to buy the shares at $ 168, he loses $ 3 per share, for a total of $ 300. This means that he nets a loss of $ 165.
Covered call writing, on the other hand, is safer because the writer already owns the stock, so there is no fear of an open-ended loss from being forced to buy the stock on the open market.
With this technique, you sell short one call option for every 100 shares of stock that you have. For example, if you have 210 shares of IBM, then you can sell 2 calls. Selling the calls will generate income. If, when the options expire, the stock is trading at or below the option strike price, then you keep the premium. If the stock is trading above the strike price, then you have to sell your shares at the strike price so, at worst, you lose some appreciation.
The key to covered call writing is to locate an option that is "out of the money" (e.g. with a strike price above the current stock price), that will expire in 1-3 months, and that offers a good premium. With this method, you may be able to earn an extra 8 to 10% annualized on your stock position.
In the example above, IBM was trading at $ 157 and the 165 call expiring in September (one month from now) was trading at $ 1.35. Since your 200 shares were worth $ 31,400 and the 2 options earned you $ 270 in premium, you made a .86% return for 1 month. This equates to an annualized 10.8% return!
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