What Is Covered Call Writing?

by | Dec 6, 2008 | Asset Management, Stock Market Comments

[display_podcast] (Warning: math ahead!)

Covered call writing is when you own a stock (or buy a stock today)

…and also sell (or write) a call option against that position.

The main thing people forget about covered call writing is this: anytime you sell something, you are bringing money into your account.
Just remember that as we walk through the example.

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Say we’re going to buy XYZ at $32/share.  1000 shares will cost us $32,000
It’s December, so let’s look at the April $35 call options.

The April 35 Call options are now trading at $2.40/contract.
We sell 10 of them and bring $2400 (not including commissions) into the account.

Your net cost to buy 1000 XYZ is essentially $29600 ($32,000 less the $2400).

Or, said another way, instead of paying $32, you bought the stock for $29.60/share.

Now what?

Well, there are three basic outcomes whenever you own a stock:

1. The stock goes UP
2. The stock does nothing.
3. The stock goes DOWN

Bad news first…what happens if the stock goes UP?
Between now and April…four months…if the stock moves beyond $35, your stock will get “called” away.

If the company were to be taken over…or cure cancer…or announce some event that would cause the stock to skyrocket, this can backfire.
That’s why it’s not a good idea to write calls on volatile stocks.  This strategy works better on plodders.
See, when you sold (“wrote”) the call option, you agreed to sell the stock if it exceeded $35 between today and the day it expires in April.
So if the stock goes up to $36, or $66, …or even $106…well, your shares are sold away from you at $35.  You only get $35.

But look at it another way: If the stock moves beyond $35, OK, the MOST you can get is $35.  But your net cost was $29.60, and it was sold at $35.
A net profit of 18% within four months.

Oh, and one more thing. If the stock gets called away from you at $35…

Yes, you make 18% inside four months.  That’s true.  But you also get $35,000 cash (because the stock was sold) deposited into your account.  To invest again.

OK, so…what if the stock does nothing?
Between now and April...four months…if the stock does not exceed $35, the option (which you sold) will simply expire worthless, and you simply keep the money.

Remember, you sold it way back in December at $2.60.  Keep the money in your pocket.  And you still own the stock.  Pretty good!  You put money in your pocket while the stock did nothing!  Now you can do it again!

Yeah, but what if the stock goes down?

Between now and April...four months…if the stock moves below what you paid for it, stop and think for a second…no one will exercise an option to buy the stock at $35. Because they can buy it in the market at the current price.  Remember, you sold that call option way back in December at $2.60.  Keep the money in your pocket.  And you still own the stock — at a net price of $29.60 — so your loss is probably less than someone who bought it at $32 the same day you bought.  Good for you!  You put money in your pocket while the stock actually went down!  Now you can do it again!

By the way, these are not made up numbers.

This is a REAL company that YOU are familiar with — and probably use their product every day.  I do.
It’s a stock that virtually everyone in the United States is familiar with and trades on the New York Stock Exchange.

By the way, at $32, this stock carries a current yield of 5.70%, a lot more than money markets.
For more additional information, including the name of the stock, call the office at 732-223-9000.