Tarkblog

My foray into options trading has led me to a really neat investment - the covered call.

Let’s examine what a covered call is and what it can do for you (or me, in this case).

First, I need to own 100 shares of a stock. In this case, I’m going to use Intel (INTC), because I already own >100 shares. INTC is currently trading at $20.85.

I look at my option screen for April and see a call option for Intel, strike price of $22.50 for $0.27. What this means is that if you bought this option, ( for $0.27 * 100, or $27.00 ) you would have the ability to buy 100 shares of INTC for $22.50 a share. Now, as long as Intel is below that, there’s no reason I’d want to buy it at $22.50 a share. But if Intel goes above that in the next 53 days, then it’s to my advantage because I have a contract that allows me to buy it at $22.50. Buying that option means I’m gambling that the price is going to go up above the strike price.

Now, I own 100 shares of Intel. Because of this, instead of buying the option I could actually sell one to the open market. That is, I could create an option contract and sell it for ~$27.00. This now means that someone out there owns the option to buy my shares of Intel from me sometime within the next 53 days. That may not happen, in which case their option would expire worthless and I would have made $27. Or it may happen. Let’s see the possibilities:

1) Intel stays relatively stagnant. The option expires worthless. I made $27 ( minus broker fees ).

2) Intel goes UP, above $22.50. Here I have two possibilities: I could buy back my option contract for the current going price (which is probably HIGHER than the $27 I sold it for in the first place). Or, I could let someone exercise the option and buy my shares from me. I would get paid $22.50 a share for the 100 shares of Intel, which doesn’t upset me much because I paid less than that for it. The downside to this is that if the price goes WAY up, my profit is capped at $22.50 a share. I’m basically limiting my profit.

3) Intel goes DOWN. Again, most likely the option will expire worthless, meaning I made $27. However, since Intel is now DOWN the value of my 100 shares of stock is lower.

This strategy is called a covered call because you are selling a CALL option on the open market, but if the option is exercised you have it “covered” because you own the stock.

By selling a covered call option, you are taking on a little bit of extra income but potentially capping yourself if the stock goes way up in the short term. This is good for a stagnant-to-slowly rising stock. Note that you still make a little bit of money even if the stock goes down, however the underlying decrease in the stock value quickly takes that away.

But, if you own 100+ shares of a stock and are planning on keeping that investment for a while, a covered call might be a good way to squeeze out a little bit more money from your investment.

This entry was posted on Monday, February 26th, 2007 at 7:37 pm and is filed under Random Thoughts. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.