Writing Covered Calls

When you’re ready for writing covered calls, you have two choices:  You can write covered calls on your own using a self-service, online brokerage, or we are here to help at Capital Wealth Planning. My name is Kevin Simpson. I invite you to call me personally at 239.593.2100 to discuss your unique situation.

(Quick note:  If you haven’t already, check out Free Covered Call ebook? For an overview of the ins and outs of covered calls.)

 Either way, you’ll place your order with a live representative at an online brokerage firm.  Phone calls are typically recorded, which is why brokers aren’t allowed to make trade orders left on voice mail.  To be efficient and accurate – and to make sure neither you nor your broker makes any mistakes – it’s important that you say the right things.

Luckily that’s easy.

Here’s an example.   Let’s say you have purchased 500 shares of Kellogg stock; today those shares are trading at $52.  You decide to write covered calls on those shares.  After checking out the possibilities available, you decide selling the March 2010 calls at a strike price of $55 is your best option.  Since you own 500 shares, you write five contracts (one call equals 100 shares).  You don’t want to accept less than $1.50 for the calls you write, so you place a limit order specifying $1.50 as your asking price.  (Any offers that come in at less than $1.50 will automatically be rejected.)   You also have the option of making your order “good for the day” or “good-till-canceled.”   “Good for the day” means just what it sounds like; your order expires at the end of the day if it goes unfilled.  “Good-till-canceled” orders stay active until – you guessed it – you actually cancel the order.  Otherwise they stay in play and will be executed whenever the asking price you set is met by a buyer.

To place the above order you call your broker and say, “I would like to write five covered calls on my Kellogg shares.  I would like to sell five contracts on $55 March 2010 calls at a limit price of $1.50; the order is good for the day.”  (Or you execute this trade using an online trading service.)

 Make sense?  To sum up, you write five 100-share contracts on Kellogg; on a total of 500 shares; at a strike price of $55; the expiration date for those calls is expiring March 2010; and you will only sell those covered calls for $1.50 or more.  If the order goes unfilled at the end of the day’s trading, it is canceled.  (And, of course, you could place another order the next day if you like.)

Writing Covered Calls Ensures You Are “Covered”

Let’s take a quick step back to make sure you understand an important concept. 

In order to write a covered call, you need to use both an ETF and an option.  The reason that call is considered “covered” is because the option you sold is “covered” by the underlying ETF shares that you own.  Think of it like collateral – you’re offering to sell a car at a certain price… and if a buyer comes along, you have the car ready to trade for cash.  A naked call is an option sold without an underlying security to back it up – if a buyer comes along, you’ll have to come up with the security.

Writing covered calls is a low risk investment technique, because you are protected by the shares you already own.   That’s why writing covered calls can be done by anyone using any type of investment account – including your retirement account.

So when you write covered calls, think of yourself as an ETF landlord. You rent your property – in this case shares of an ETF that you own – for a given time, and in return expect to be paid for renting your property.  The money, or “rent,” you receive is then yours to keep, spend, or reinvest.

In other words, you receive rent payments upfront by writing covered calls.

Write a Covered Call – a Detailed Example

Here’s another example of what happens when you write a covered call:

• You buy 100 shares of SPDR, the S & P 500 ETF, for $110 per share, in the month of December. You take a look at the options available on SPDR to find out the current prices for those options. 
• You decide the market will stay relatively flat for the next few months, and you feel $115 is a realistic ceiling for upward movement during that time frame.  (You want to hold on to the shares, but you decide you’ll be happy to let them go if they hit $115.)  Currently the January $115 option sells for $1.18 per share.
• Each option contract covers 100 shares of stock, so the $1.18 call option is worth $118.00 per 100 shares.  You own 100 shares of SPDR, so if you write a call on that ETF, your call is “covered” by those shares.
• You sell a January $115 covered call on SPDR for $1.18 per share, or a total of $118.00.  If the ETF hits $115 at any time before the January expiration date, your shares could be called away, but you will be paid $115 per share for those shares. 

So what could happen?

• Let’s take a quick step back.  You originally purchased 100 shares of SPDR at $110 for a total investment of $1,100.  You then sold a covered call for $1.18, or a total of $118.00.  Your cost base is now $982 ($1,100 – $118. = $982.)  Or you could look at it another way:  You have already made a profit of $118, even if the price of SPDR stays flat.  Best of all, you receive those funds immediately – to use or invest as you see fit.
• If SPDR closes at $115 or higher before or at the January expiration date, your shares may be called away by the buyer of your covered call.  He will pay $115, regardless of whether SPDR shares are trading at an even higher price.  Of course the buyer hopes SPDR will close above $115; that’s the only way he will be able to make a profit.  (In fact, since he invested $1.18 per share in the options, SPDR needs to reach a price higher than $116.18 in order for him to make a profit.)  Your point of view is different:  If SPDR hits $115, and your shares are called away, you still make a nice profit.  You’ll make $5.00 per share, plus the original option price of $1.18; your $6.18 per share profit is a return 5.6% – in two months!
• If SPDR stays below $115 and the covered call expires, you still make money because you received $1.18 per share when you wrote the call.  Since the shares did not hit $115 by January, the contract was not executed.  You keep the shares, keep the $118, and can write another covered call.
• If SDPR falls to a level below your original purchase price of $110 per share, you reduce your loss because your new cost is $108.82 ($110 – $1.18 = $108.82.)  You only lose money if SDPR falls below $108.82; writing a covered call creates an adjusted cost and a new break-even point.   Every time you sell subsequent covered calls you further reduce your cost base and reduce your risk of loss.

 In short, as long as SPDR stays below $115 per share, you maintain ownership of the shares you purchased; at the expiration date, you can sell those shares or write another covered call. And in the meantime you also receive dividends on your SPDR shares; currently the return is slightly over 2% per share.  Even if you write covered calls, you are still entitled to dividend payments as long as the underlying shares have not been called away.

Writing Covered Calls Can Generate Greater Returns and Cash Flow

Here’s a quick summary of writing covered calls:

• A covered call trade requires you to own the shares you write covered calls against.
• The proceeds of writing covered calls are received immediately and are yours to keep regardless of the outcome of the contract.
•  If shares close above the strike price they will called away from your account automatically and the strike price funds will be deposited in your account.
• Covered calls can be written for any type of stock or ETF, including retirement accounts.  You cannot write covered calls for mutual funds.
• Covered call trading generates additional income and reduces overall risk. See Why Exchange Traded Funds

 

 A few things to keep in mind:

1.       If the underlying shares of the covered calls you write appreciate significantly, the option is likely to be exercised.  In that case you receive the strike price and you keep the covered call premium.  You will make a profit, but you do risk the opportunity to capitalize on a significant increase in share price.

2.       If the underlying shares of the covered calls you write stay relatively flat, your option may not be exercised.  You keep the shares and you keep the premium.

3.       If the underlying shares of the covered calls you write go down in value, the option most likely will not be exercised.  You keep the shares and you keep the premium, which helps offset some or all of the loss in value of the underlying shares.