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by Das Brain

Intro To Option Trading – Part 6b

What else can I do with option contracts?

Selling Covered calls

First of all let’s define what “covered calls” mean. Covered call means that you are selling call option contracts on shares that you already own, and taking in the income from that sell transaction. Therefore, selling covered calls is an income strategy with limited downside protection. However, most people think that selling covered calls is an income strategy with no downside or possible losses, but that is not true, one should understand that there is a potential to lose with this strategy as well.

The next few paragraphs will give you an example of selling covered calls. Let’s say you have purchased 500 shares of Microsoft NYSE:MSFT at $28 and in the coming months you want to have some downside protection and bring in some income as well. Generally, what you want to do is sell call contracts that are OTM or “out of the money” with a strike price that is far away from the price that you purchased the stock. So, you will want to sell a call contract that you think the stock price will not hit by expiration date. An example would be a call contract 4 months out with a strike price of $35. The chances of Microsoft’s stocks to go over $35 which is a jump of $7+ or over 20% is quite unlikely in 4 months. Remember that if it is over the strike price at expiration you can lose your Microsoft shares.

For the example in this post, let’s go ahead and sell 5 call option contracts with a strike price of $35 for 4 months in the future on the current hypothetical 500 shares of Microsoft that you own. A few very important factors to note is the following:

Purchased price for MSFT: $28
Current Stock price of MSFT: Let’s say the current price is $29
The price / premium of the call options that you sold: You sold the contracts for $2.5 ($250 each contract)
Number of contracts sold: 5 (5 contracts X $250 = $1250
The strike price of call option contracts you sold: $35

Having outlined the details of this selling covered calls strategy above, let’s do some important calculations to see where or what price Microsoft stock price must trade at so you as the call option contract writer or seller can retain your income. First let’s figure out the break-even point which is the current stock price $29 minus the premium received for 1 contract that was sold $2.50 for a break-even price of $26.50. If the stock price of Microsoft falls below $26.50 you will incur a paper loss before expiration.

There are 3 possible outcomes of this strategy.

1. Stock above the strike price at expiration

If Microsoft’s stock price advances higher than the strike price of $35 chances are you the covered call writer / seller will be assigned. Assigned means that the call purchaser is going to exercise the option contract and you will have your 500 shares taken away from you at the strike price of $35. The downside, here is you lose your shares, but the upside is you lose them or have to sell them to the call option purchaser at $35, and you’ve purchased them at $28. You have made money on the selling of the shares to the option purchaser, so $35 – $28 = $7 X 500 shares = $3500 and in addition you get to keep the income of $1250 from you selling the call option contracts. Your total profit from this strategy given this scenario is $4750 minus any commissions.

2. Stock falls below the break-even point at expiration

If Microsoft’s stock price is below the break-even point of $26.50, then the unexercised call option contracts that you sold to the purchaser would expire worthless. This means you do not get assigned. In this scenario, you keep the income you have made from selling or writing those call option contracts which is $1250, however your since you still own 500 shares of Microsoft at $28 and the stock price is currently trading below $26.50 you do lose some money on paper.

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3. Stock settles between the strike price and the break-even point

If the underlying stock of the call option contracts, which is MSFT’s stock price is between the break-even point of $26.50 and the strike price $35 at expiration, chances are unlikely that you the call option contract writer /seller will be assigned (have your shares sold to call option purchaser). Therefore you will retain your 500 shares in Microsoft and you will keep the income earned from selling the call option contracts.

A few things to remember is that the outcome of the selling covered call strategy is completely dependant where the stock price is at expiration and also that the downside protection for the Microsoft stock you own is provided by and limited to the income from the sale of the call option contracts. Your position will begin to suffer a loss once the underlyging stock price declines by an amount greater than the call premium income received.

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This entry was posted on Thursday, April 5th, 2007 at 9:50 am and is filed under Option Trading. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.