The Covered CallThe Covered Call

An Investment Strategy An Investment Strategy to to

Keep You in the MoneyKeep You in the Money and and

Out of TroubleOut of Trouble

Maureen MagnerMaureen Magner

Presentation OverviewPresentation Overview

Historical look at the options marketHistorical look at the options market Review of termsReview of terms Covered call exampleCovered call example Rules of the gameRules of the game Commissions and the market makerCommissions and the market maker The tax advantageThe tax advantage

Investment ObjectiveInvestment Objective

To make money for the investor or yourself over a broad range of stock prices.

Evolution of Risk Management

Job sold short

The covered call in 15th century Venice

Herring and the 16th Century Futures Market

Options innovations at the Amsterdam Bourse in the 17th century

April 26, 1973April 26, 1973

The first government regulated exchange in the world’s history to deal with stock options opened –

CBOE Chicago Board Options Exchange

Five Option ExchangesFive Option Exchanges

CBOE Chicago Board of Options CBOE Chicago Board of Options ExchangeExchange

AMEX American Stock ExchangeAMEX American Stock Exchange

PHLX Philadelphia Stock ExchangePHLX Philadelphia Stock Exchange

Pacific ExchangePacific Exchange

ISE International Securities ExchangeISE International Securities Exchange

The Options Clearing The Options Clearing Corporation (OCC)Corporation (OCC)

The common clearing entity for all The common clearing entity for all SEC-regulated options SEC-regulated options

transactionstransactions

Selects companies to be listed on Selects companies to be listed on the option exchangesthe option exchanges

Guarantees that the terms of an Guarantees that the terms of an options contract will be honoredoptions contract will be honored

Stock OptionsStock OptionsTwo Basic FlavorsTwo Basic Flavors

◊ Call Call : The right to : The right to buybuy 100 shares of 100 shares of the underlying stock at the strike the underlying stock at the strike price before the expiration date.price before the expiration date.

◊ PutPut : The right to : The right to sellsell 100 shares of 100 shares of the underlying stock at the strike the underlying stock at the strike price before the expiration date.price before the expiration date.

LEAPSLEAPS

Long-term Equity Anticipation Long-term Equity Anticipation SecuritiesSecurities

They are just like regular optionsThey are just like regular options

except for except for

longer duration.longer duration.

Expiries can be out as far as Expiries can be out as far as

3 years and 3 months.3 years and 3 months.

What is a Covered Call ?What is a Covered Call ?

A call is considered covered when its A call is considered covered when its seller owns the underlying stock.seller owns the underlying stock.

For example: If a person sold a stock For example: If a person sold a stock option on Coca-Cola when he/she option on Coca-Cola when he/she owned 100 shares of Coca-Cola, he owned 100 shares of Coca-Cola, he would have sold a “covered Coca-would have sold a “covered Coca-Cola call”.Cola call”.

Who Should Consider Who Should Consider Covered Calls?Covered Calls?

An investor who is neutral to An investor who is neutral to moderately bullish on a specific moderately bullish on a specific stock. stock.

An investor who is willing to limit his An investor who is willing to limit his upside potential in exchange for upside potential in exchange for some downside protection. some downside protection.

How Day Trading WorksHow Day Trading Works

Andy Borowitz, Andy Borowitz, The Trillionaire Next DoorThe Trillionaire Next Door, 2000, , 2000, HarperCollinsHarperCollins

Buy Stock

Visit Sex Sites

Sell Stock

BecomeTrillionaire

Log-on

Buy 300 Shares of Stock Buy 300 Shares of Stock at $20 shareat $20 share

P R O F I T

L O S S

Stock price

Payoff

20

$6000

Sell 3 Naked Calls Sell 3 Naked Calls $7 / Share, E=$15, Cost=$2100, t=6 $7 / Share, E=$15, Cost=$2100, t=6

mo.mo.

Stock price

E

Profit

22

$2100

P R O F I T

L O S S

Covered Call ExampleCovered Call Example

Buy 300 sharesBuy 300 shares $20/share$20/share +$6000 +$6000Sell 3 calls $ 7/shareSell 3 calls $ 7/share E=$15 E=$15 -$2100-$2100 +$3900+$3900

Stock priceE

$4500$3900

13

L O S S

P R O F I T

$15 x 300 = $4500

Annualized Return ScenariosAnnualized Return ScenariosOn a Six Month InvestmentOn a Six Month Investment

Stock falls $6 Stock Stock rises Stock falls $6 Stock Stock rises $6$6

(-30%)(-30%) unchangedunchanged (+30%)(+30%)

Stock Stock -60%-60% 0% 0% +60%+60% alonealone -$6/share-$6/share - - +$6/share+$6/share

Naked Naked P= (P-(S-E))=P= (P-(S-E))= (P-(S-E))=(P-(S-E))=call call +$7/share +$2/share+$7/share +$2/share -$4/share-$4/share

Covered Covered +15.4% +30.7% +30.7%+15.4% +30.7% +30.7%callcall +$1/share +$2/share +$2/share +$1/share +$2/share +$2/share

How do we How do we limit the losslimit the loss in the in the event the stock starts to crash?event the stock starts to crash?

Place a stop-loss order to sell the stock when it has declined to a predetermined

price and buy back the call at a much reduced price.

orBuy back the covered call option at the

much reduced price and immediately write it again

at a lower strike price.

Selecting Stocks & OptionsSelecting Stocks & Options Buy a stock that you believe is going to do Buy a stock that you believe is going to do

well and you would feel good about owning.well and you would feel good about owning. Always compare potential annual returns Always compare potential annual returns

on a call before choosing a stock for on a call before choosing a stock for covered call writing.covered call writing.

The safest covered call is the one with the The safest covered call is the one with the lowest strike price.lowest strike price.

Look at the stock’s volatility- read the Look at the stock’s volatility- read the company news about potential merger. company news about potential merger.

Usually lower priced stocks have higher Usually lower priced stocks have higher premiums (percentage-wise).premiums (percentage-wise).

Higher options volumes generally means Higher options volumes generally means less of your money to the market maker. less of your money to the market maker. Look on www.pcquote.comLook on www.pcquote.com

Microsoft Excel

Worksheet

www.cboe.com

Commissions ExampleCommissions ExampleCharles Schwab on-line accountCharles Schwab on-line account

www.schwab.comwww.schwab.com Open a $5000 account with SchwabOpen a $5000 account with Schwab $29.95 for the first options contract$29.95 for the first options contract $2.00 for each additional options contract$2.00 for each additional options contract $29.95 for up to 1000 shares of stock$29.95 for up to 1000 shares of stock

If fewer than 10 trades per monthIf fewer than 10 trades per month 3 cents per share over 1000 shares3 cents per share over 1000 shares

Total commissions on covered call example: Total commissions on covered call example: $29.95 + (2 x 2) + $29.95 = $29.95 + (2 x 2) + $29.95 = $63.90$63.90

Taxation of Stock OptionsTaxation of Stock OptionsThe Un-simple StoryThe Un-simple Story

Capital losses can be offset dollar-for-dollar Capital losses can be offset dollar-for-dollar against not only capital gains but also $3000 against not only capital gains but also $3000 of ordinary income.of ordinary income.

Premium money received is not considered Premium money received is not considered taxable until the covered call ends.taxable until the covered call ends.

When the covered call is not exercised, the When the covered call is not exercised, the premium is a short-term capital gain.premium is a short-term capital gain.

If the call is exercised, the premium plus the If the call is exercised, the premium plus the strike price become the sale price of the strike price become the sale price of the stock.stock.

If profit is made on an in-the-money covered If profit is made on an in-the-money covered call, the IRS says that it is short term capital call, the IRS says that it is short term capital gain – even if the stock is called.gain – even if the stock is called.

AdvantaAdvantagges of the Covered Calles of the Covered Call Less risk than just buying stock Less risk than just buying stock Take in the premium of the call Take in the premium of the call Earn dividends (if any) on the stockEarn dividends (if any) on the stock If the stock is not called away, sell If the stock is not called away, sell

additional calls to bring in additional additional calls to bring in additional premiums. premiums.

DisadvantaDisadvantaggeses Forfeit the upside potential of a stock Forfeit the upside potential of a stock

price increaseprice increase Commissions and the market makers Commissions and the market makers

spreadspread

BibliographyBibliography

Ansbacher, Max. The New Options Market. Fourth Edition. New York: John Wiley and Sons, Inc., 2000.

Borowitz, Andy. The Trillionaire Next Door. New York: HarperCollins Publishers, 2000.

Gross, Leroy. The Conservative Investor’s Guide to Trading Options. New York: John Wiley & Sons, Inc., 1999.

Friedentag, Harvey C., Stocks for Options Trading: Low-Risk, Low-Stress Strategies for Selling Stock Options – Profitably. Boca Raton: CRC Press LLC, 2000.

Murphy, John J. Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications. Paramus, NJ: New York Institute of Finance, 1999.

Steinherr, Alfred. Derivatives: The Wild Beast of Finance. New York: John Wiley & Sons, Inc., 1998.

Stringham, Edward. The Extralegal Development of Financial Trading in Seventeenth-Century Amsterdam. http://mason.gmu.edu/~estringh/stringham_paper.pdf