Getting your head around options can be really tricky, and so most people don’t bother. This is a shame, because options can be a really useful tool in your investing arsenal. In this post, we are going to look at a basic options play that should allow the careful investor to derive greater returns from stock that is expected to trade relatively flat over the short-medium term.
So, let’s get some terminology out of the way. An equity option, e.g. an option on a stock can be either a call or a put. A call gives the holder the right to buy the underlying equity at a certain price (called the strike price) at or before some predetermined date in the future (the expiration date). A put is exactly the same, except it is a “right to sell” the underlying security. Here is a quote for an option on Eaton (NYSE:ETN):
When I pulled this quote, the market price of the underlying security, a share of Eaton, was $53.55. The above quote is for a March 19 call with a strike price of $57.50. Breaking it down, this means that the purchaser of this option will pay $25 for the right to buy 100 shares of ETN at $57.50 per share. Since this is what is known as an “American style” option, as opposed to a “European style” option, the buyer can exercise the option at any point before expiration date. By contrast, European style options can only be exercised on their expiration date.
Every transaction must necessarily involve two parties, and so it is no surprise that just as you can buy a call, it is also possible to sell a call, and receive as payment the “bid” price, or in this case $15 for a round lot (options trade in lots of 100 shares 0.15 * 100 = $15). Ok, so you’ve sold a call (called going short) and pocketed your $15. If the market price of ETN reaches somewhere in the region of $57.60 by March 19, the option will likely be exercised, and you will have an obligation to sell the other party 100 shares of ETN at $57.50 per share. If you don’t already own ETN shares, you will have to go out on the open market and buy the shares (at a price potentially well above $57.50) in order to sell them to the other party. This is called being “naked.”
So the basic strategy of writing covered calls is to pick some shares in your portfolio that you think will trade quite flat and that you are somewhat ambivalent about holding, such as shares in a company that most analysts have as a hold recommendation with say a negative outlook. When you write the covered call, pick a strike price that is say 10% above the current market price of the underlying security and pocket the commission. Let’s say for arguments sake that you have 100 shares in XYZ whose current market price is $10/share. Let’s also say that you can short a call for $0.30 per share whose strike price is $11 and which expires in a month. If the market price of the share reaches $10.70, the call will expire as worthless leaving you with no outstanding obligations, yet you will have derived an extra $0.30 per share, taking you from 7% return on your position in XYZ on the month to a 10% return for the month. Then you can decide whether you want to do the same thing next month, and through careful and deliberate use of covered calls can substantially increase your return on your portfolio in a way that is quite conservative.
