A basic rule in trading is to ensure a full protection of your capital. So the strategy of selling a call option should be applied only to securities that you already have – thus comes the term covered calls.
The concept of this strategy is relatively simple and if you use it properly, you can earn considerable income in a short period of time, with minimal risk. But this strategy requires certain effort and thought. A simple description of the process will illustrate the need of complex check.
Consider Visa – a company that most of you are familiar with. Its shares are currently trading for about $ 90 a share. It is supposed that you have done your analysis and have determined that the current price of Visa is a good long term investment. At the same time, the current market environment shows a lack of enthusiasm on the market and prices move without clear direction.
If you buy 1,000 shares at a price of 90,000 dollars, then you sell 10 call options maturing in October 2008 in the strike price of 96 dollars that currently worth $ 210 for a contract, you would take 2100 dollars.
As a seller of options you have agreed to give the buyer 1,000 shares of Visa at a price of 96 dollars, when the deadline comes. But remember that the buyer pays $ 2.10 per share, which means that the transaction will be profitable only if the securities are traded over 98.10 dollars.
So the maturity has two options:
- The Visa price is below 96 dollars, you save the shares and take 2,100 dollars.
- The price is over 96 dollars, so you sell the shares to the buyer with the option for 96, but you also hold the premium of 2100 dollars. You get 98100 dollars in 90,000 initially invested. This is a 9% return for two months.
This is basic math behind the sale of covered call options. However, scenarios are not as clear as these two possible results.
First, the share price could go down. If you act in a similar way with Fannie Mae and Freddie Mac, even after the shares fell more than 50%, no earned premiums could compensate the significant decline in prices.
So, in first place, you should use the strategy only for business that you know. And if the share price rises, and you must deliver shares, do it without any emotion and doubt.
Secondly, write call options on shares that are reasonably priced (undervalued). Highly falling markets offer the best opportunities for reasonable selling of covered calls.
If the stock price falls, you still possess asset, although impaired. If shares rise, you earn a good income in a short period of time. In the example with Visa – 9% for two months, which is return of 54% for a year.