Options—Where Do I Begin? Part 3

The general feel when buying a stock is: it’s hopefully going to go up. I’m going to make money or I’m going to lose money. Nobody enjoys the feeling when the stock declines in value, but at least I will know if I’m right or wrong. What about when it does absolutely nothing? I might have great prospects for the stock, but it just sits there, maybe within a $2 to $5 range. Because we are option traders, let’s do something about it!

So far we have discussed how to start options trading and how to put on a bullish strategy by buying a call option. The great aspect of options is that you can combine options with stock and options with other options to create very unique strategies that fit your outlook on a particular stock or index.

We will start with a combination of stock and an option—the covered call. A covered call is a combination position that involves buying shares and selling a call against them. There is more than one reason to put this strategy on, and each will represent a trader’s outlook or expectations for a particular stock. One reason is that the stock was purchased and had a great bull run. Now, it has stalled and the trader has become a willing seller of the stock at a chosen level (the strike price), but would still like to generate income from the stock by selling calls against it. Another reason could be that the stock was purchased and doesn’t seem to be a strong leader, nor is it falling through the proverbial floor. Let’s use the former example to illustrate the usefulness of a covered call strategy.

First, we bought a stock which has done well. We have made a decent amount of money, but our outlook is now neutral to bearish and would like to take in a credit from selling the at-the-money call. Its hypothetical ticker is LZY, trading at $44.65 per share. We have also looked at the option market and see that the market for LZY Sep 45 calls is $0.90 bid, offered at $1.00. Let’s generate some income from this lazy stock and perhaps sell it.

First, if we want to sell the option immediately we will sell the Sep 45 call at $0.90. We could enter a limit order to sell it at $0.95 or $1.00, but we can sell it now at $0.90. How much more can we get from this trade, at which point will we break even, and how much can we lose?

 

Strike Price – Stock Price + Call Credit = Max Gain

$45.00 – 44.65 + 0.90 = $1.25

 

Stock Price – Call Credit = Break Even

$44.65 – 0.90 = $43.75

Break Even  = Max Loss

$43.75

 

We can see how all the components fit together if we break them apart:

 

LZY Stock Price

LZY Stock Position Value

Short Sep 45 Call Value

Premium Credit

Profit/Loss

40

(4.65)

0.00

0.90

(3.75)

42

(2.65)

0.00

0.90

(1.75)

43.75

(0.90)

0.00

0.90

0.00

44

(0.65)

0.00

0.90

0.25

46

1.35

(1.00)

0.90

1.25

48

3.35

(3.00)

0.90

1.25

50

5.35

(5.00)

0.90

1.25

 

Graphically it looks like this:

You will notice that the covered call looks similar to a short put position. This is known as a synthetic position. All 4 option positions can be recreated using the 2 other instruments. In this case: Long Stock + Short Call = Synthetic Short Put.

If the stock stays above our breakeven point ($43.75) then—excluding commissions, taxes, and other variables—we will make a small profit, a maximum of $1.25. Ideally, we would like the stock at expiration to be above $45. Why? Effectively we are selling the stock at $45.90 because we took in a $0.90 credit, and have an obligation to sell the shares at $45. Of course, things can go wrong as well. Below our breakeven point we will start to incur losses. One solution is to take the loss and get out before the stock falls any further. However, you can “roll” the call down to create a new covered call strategy at a lower exercise price. We don’t have time to run through the steps today but there are informational videos and blogs on doing just that on CBOE’s website.

A distinction must be made at this point. This strategy, as already stated, is a covered call. This is not to be confused with a buy-write. A covered call strategy happens in 2 stages. First, the stock is purchased. Second the call option is sold, which could be days, weeks or months later. A buy-write happens in one trade. For a little comparison, the CBOE has an index that tracks the performance of consistently buy-writing the S&P 500. It has consistently outperformed the SPX Total Return Index (which tracks the performance of SPX while reinvesting dividends), even through tumultuous times such as 2008, and August 2011. For more information on the BXM click here, http://www.cboe.com/micro/bxm/

In short, a covered call strategy is useful for a few reasons: first, it allows you to potentially profit from a stock that has hit a plateau. It also allows you to be paid to be a willing seller of the shares. If the stock closes above the strike at expiration, the shares will be called away. This isn’t the only starter strategy but it’s one of the most common strategies that professionals educate their clients with.