Here's how covered calls work
(you may want to print this page for later review)
We will be giving an actual example of a covered call buy/write below, but first some definitions and rules.
DEFINITIONS AND RULES
Legalistic Definition - A covered call option is a contract which conveys to its holder the right, but not the obligation, to buy shares of an underlying stock owned by the seller of the covered call, at a specified price (the strike price) on or before a given date (expiration day). The seller of the call option receives some money (premium) for each share offered from the buyer for this right. The seller of an option is, in turn, obligated to sell their shares to the buyer of the option at the specified price upon the buyer’s request at any time before the given date.. After this given date, the option ceases to exist.
Simple Definition - Covered calls are rights (options) you sell to someone for some money (premium), giving them the right to buy stock you own, at a fixed stock price (strike) within a fixed time period (expiration). The holder of the call can buy the stock at the strike price at any time before expiration. The call contract expires at expiration if not exercised. The buying of stock and the selling of call options on that stock is called a buy/write (buying the stock and writing the option contract). Thousands of companies have put and call options traded on their underlying stock, resulting in thousands of put and call options that are traded every day. There are no contract documents that are signed. Options are traded just like stock. We will be describing only covered calls in this "Short Course", which means that the owner of the stock sells the calls to someone else. If the stock is called, the seller of the calls is "covered" with actual shares and can deliver the stock to the buyer of the calls.
The following rules have been established for options trading:
1. The expiration day for equity (stock) options is the Saturday following the third Friday of the month. Therefore, the third Friday of the month is the last trading day for all expiring equity options. However, some professional traders can go in on expiration Saturday and "clean up" expiring options that have a little value. Options Calendar
2. Options are traded with expiration dates for the next two months and then a variety of months (and years) after that. These are called option cycles.
3. Stock options are generally traded in $5.00 increments of strike price except for low value stocks (below $35.00) where the increment is $2.50. In 2010, a few stocks with $1.00 strike prices were introduced to provide more flexibility in buying and selling puts and calls.
4. In-the-money calls have a strike price less than the stock purchase price. Out-of-the-money calls have a strike price higher than the stock purchase price. The Analyzer can analyze in-the-money and out-of-the-money buy/writes. For our lists and portfolios, we consider only out-of-the-money buy/writes since we anticipate a double return - increase of share price to the strike price and the premium received from the sale of the call.
5. Option symbols identify the underlying stock, the expiration month, and the strike price. In 2010, a new method of identifying these parameters was introduced but can vary by exchange or brokers. For this website, the Analyzer uses a symbol like this:
It has been found over time that covered calls provide one of the safer option strategies. Covered calls can be traded in IRA accounts. Call contracts are traded just like equities (stocks) in large volumes every trading day. There is a commission on the option transaction.
On May 22, 2010 (expiration weekend), the Analyzer found this buy/write:
Buy 200 shares of OXFORD INDUSTRIES (OXM) at $19.57 (closing last trade price) and sell 2 call Out-of-the-Money contracts of OXM1019F22.5 (Jun$22.50) at $0.55 (closing bid price) expiring on 6/19/2010. Cost is $3,934, and income from sale of the calls is $97 and includes your commissions. Annualized return if called is 212%.
We will use it for our example:
EXAMPLE Oxford Industries 
Before running the Covered Call Analyzer we input $5,000 in the money available field along with the default parameters. We were looking for stocks to publish in our Conservative "Stocks to Consider" list. Oxfird Industries (OXM) was listed by the Analyzer as qualifying to the default parameters for our Conservative "Stocks to Consider" Lists. As a subscriber, you could have changed the parameters to find more conservative or more aggressive stock/call combinations.
The Analyzer suggested buying 200 shares of OXM at $19.57 per share for a total cost of $3,934, assuming $19.95 in commission charges (The Analyzer calculates the number of shares, in blocks of 100, and total cost after commission insuring that you do not go over the money available of $5,000. You can put any value into the money available field before running the Analyzer, but remember that you have to have enough money to buy at least 100 shares).
You could leave these shares in your account and hope that the stock moves up. Actually, the price will probably fluctuate - go up, go down, or stay the same - over the next few months. The Analyzer has identified OXM as a good covered call candidate. What this means is that you will be giving someone the right to purchase your stock (200 shares of OXM) at a predetermined price ($22.50) within a predetermined time (before 6/19/2010) and that person will give you some money ($0.55 per share) for the right to do this. The predetermined stock price at which you will sell the stock is called the strike price; the time period is set by an expiration date; and the money given is the premium. The right to do this is called a covered call option contract.
The reason it is called a covered call is because you own the stock and can deliver the shares if the strike price is reached (you have the contract covered) and the buyer of the contract calls your stock away. In most cases, this is what we want. Options are traded daily on thousands of stocks and the Analyzer helps you find good stock/call combinations (or buy/writes - you buy the stock and write the call) like OXM. We have the Analyzer select stock/call combinations that have a strike price above the stock purchase price. This is an out-of the-money call. This means that the price will have to appreciate to the strike price before it will get called away. Thus you will make more money in addition to the premium, in stock appreciation. An in-the-money call would be one that has a strike price lower than the purchase (current) price.
Let's get back to our example. The Analyzer found OXM out of all the stock/call combinations because it met all our input parameters (default in this case), had a high premium price and a large spread between the stock purchase price and the out-of-the-money strike price. The call contract that was found had a strike price of $22.50 (out-of-the-money) with expiration on the third Friday of the next month (June 19, 2010) and selling for $0.55 per share (the call bid price or premium). What this means, is that there are investors who are willing to give you money ($0.55 per share) for the right to buy your Oxford Industries stock at $22.50 a share (the strike price) within the next 30 days (actually any time before June 19, 2010). Because you paid $19.57 per share, which is lower than the strike price ($22.50), this is an out-of-the-money covered call transaction, meaning the stock price has to rise to $22.50 before it will be called away. You get the call price ($0.55 premium) for selling the call contracts as well as possible appreciation of the stock share price to $22.50 before the shares of OXM would be called away.
You call your broker on Monday morning (May 24) and buy 200 shares of OXM and sell 2 Jun22.2 (June $22.50) covered calls against the 200 shares of stock you just purchased. Calls are traded in 100 share contracts, and the call contract symbol is OXM1019F22.5 (the Analyzer determines this symbol for you). You receive $97 for the sale of the calls (this is after the default commission of $9.95 plus $1.50 per contract on the sale of the 2 call contracts). This money is like income, it goes right into your account or into your pocket and you don’t have to give it back - it’s yours, risk free. This money represents a real instant return of 2.5% ($97/$3,934). If you bought the stock on margin, the return is even greater (but margin purchases are not allowed in IRA accounts).
Now you wait for the 28 days until the option exercise date, June 19, 2010. One of four things can be true on this date - the stock price went down; the stock price stayed the same; the stock price went up, but not above $22.50; or the stock price went above $22.50.
Let’s look a each of these four scenarios:
1. The stock price went down. Your portfolio value went down, but you still have the $97, and the person that bought the 2 calls (which are contracts between you, the seller, and the buyer) is not going to take the stock away from you at $22.50 because the stock price is less than $19.57 (the original stock purchase price). If the stock went down to $16.63 (-15%), your loss would be $608 ($3,934 [cost] - $3326 [200 X $16.63]) , but the sale of the calls offsets that loss by $97, resulting in an actual loss of $510 (-13.0%0. So you are better off having sold the covered calls even though the stock price went down and didn't get called. You keep the stock, you keep the $97 premium and the call contracts you sold cease to exist after June 19, 2010.
2. The stock price stayed the same. Your portfolio value stayed the same and you still have your stock and the $97. The person who bought the 2 calls is not going to exercise, because the stock price is still $19.57 and he/she is not going to give you $22.50 for each of your 200 shares. You realize a 2.5% ($97/$3,934) real return on this 28 day investment and keep the stock.That's an annualized return of 32.1%
3. The stock price went up, but not above $22.50. Your portfolio value went up, you still have the $97, and you get to keep your stock, because the person that bought the 2 calls isn’t going to pay you $22.50 for shares selling for less than that price. You realize more than 2.5% real return because the stock price has appreciated from the stock purchase price but not enough to lose the stock and you get to keep the $97 premium. The call contracts you sold ceases to exist after June 19, 2010. In case 1, 2, and 3, you may decide to sell 2 more out-of-the-money covered calls for the next month (July) and get some more premium, since you still own the stock.
4. The stock price went above $22.50. The person who holds the 2 calls exercises. That means he/she takes your 200 shares of Oxford Industries at $22.50 each. You had a gain of $2.93 on each share that you owned ($22.50 minus your cost of $19.57), or $586 for the 200 shares. But you must pay a commission on the sale (call) of your stock, assumed to be another $19.95, yielding a gain of $566. This, added to the $97 that you received for selling the 2 calls initially, yields a total return of $663 a real return of 16.9%, or an annualized return of 219%. Your money was invested for 28 days. Your $3,934 investment. became $4,597 (+16.9%) in that short period.
The Analyzer is able to find stock/call combinations that the market makers are paying a high premium for and have a good spread between the stock purchase price and the strike price. OXM was an opportunity that the Covered Call Analyzer found among all the possible covered call buy/writes. The Analyzer does not rely on trends, formulas or charts. It assumes that the professionals have done all that and are investing their money in call contracts, thus driving up the premium values. The Analyzer finds these high paying buy/write opportunities. Our objective is to get the stock called away at the next expiration date and then use the Analyzer for find other opportunities to sell calls on.
This example demonstrates the following key points:
1. The $97 is never at risk.
2. Portfolio value will fluctuate with the rise and fall of stock prices whether you sell the options or not.
3. Commission effects are rather large, but the returns are also large. The larger the blocks of stock you buy and the more covered call options you sell, the less influence commissions will have on your returns.
4. One call represents 100 shares, so you must sell calls on blocks of 100 underlying shares.
5. If the Oxford Industries stock went to $25.00 (which it didn't) you may be upset because you missed the ride. Don’t look back. Take your 16.9% return, realized in 28 days, and move on to another opportunity using the Analyzer.
9. If the stock didn’t get called away, you may want to repeat the process of selling more covered calls for next month. If the stock did get called away, use the Analyzer to find another opportunity to re-invest the proceeds.
So what actually happened with Oxford Industries? We bought the stock on Monday, May 24, 2010, for $19.72, costing $3,964 after commissions. It opened on that Monday at $19.61 and didn't move much to close at $19.74. The low that day was $19.07 and the high was $19.89. It closed at $19.57 on the previous Friday (May 21 , 2010) and this price was used when the Analyzer was run on the weekend. The call bid price increased from $0.55 at the close on Friday to $0.60 on Monday morning since option prices tend to move in tandem with the stock price. After buying the stock, we sold the calls at $0.60 on Monday morning for $107 (200 X $0.60 - $9.95 - 2 X $1.50) after commissions. The market makers were right. As you can see from the chart below, the stock price moved radically for a few days, but then began a steady climb to $23.85 on June 18, 2010 (expiration). OXM closed above $22.50 on expiration (June 19, 2010) and the stock was called at $22.50 for each of our 200 shares. The stock appreciation was $2.78 ($22.50-$19.72 [actual stock purchase price]) or $556 for the 200 shares. Commission on the sale of the called stock was $19.95, bringing the appreciation down to $536. This combined with the initial premium of $107 yielded $643 for a real return of 16.2%, a little less than what the Analyzer calculated. Markets are dynamic, so by the time you place your trades with your broker, prices will have changed. But stock prices and option prices usually track in tandem, producing returns similar to those identified by the Analyzer. Our actual investment of $3,964 produced a return of $4,607 (16.2%) in 28 days.
See where OXM is today
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