The Covered Call Analyzer

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

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. After this given date, the option ceases to exist. 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. Wow!! This sounds pretty legalistic and complicated. Simply put, covered calls are rights (options) you sell to someone, giving them the right to buy stock you own, at a fixed price and within a fixed time period. 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 is 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.

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. Options are generally traded in $5.00 increments of strike price except for low value stocks (below $30.00) where the increment is $2.50. In-the-money calls have a strike price less than the purchase price and out-of-the-money calls have a strike price higher than the purchase price. Generally, the Analyzer only looks at out-of-the-money calls because it is looking for buy/writes that will provide a premium and some appreciation of the stock price before it is called.

4. Option symbols (using up to five letters) identify the underlying stock, the expiration month, and the strike price. How option Symbols are derived

5. Each option contract represents 100 shares of the underlying stock, so you must purchase the stock Or have the stock) in blocks of 100 shares.

Five options exchanges create markets in options, including the Chicago Board Options Exchange (CBOE), the AMEX and NYSE Options Exchanges.

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.

EXAMPLE                  CapitalSource Inc.        

An example of how this all works is given here for an actual covered call transaction.  This "Short Course" will use CapitalSource, Inc. (CSE) as the example. This example was run on the Covered Call Analyzer on the weekend of March 22, 2008 (expiration weekend).

Before running the Covered Call Analyzer we input $10,000 in the money available field along with the default parameters. We were looking for stocks to publish in our "Stocks to Consider" list.  CapitalSource, Inc. (CSE)  was listed by the Analyzer as qualifying to the default parameters for our Aggressive "Stocks to Consider" Lists See our Results Page for March 2008 (second one on page). As a subscriber, you could have changed the parameters to find more conservative or more aggressive stock/call combinations.

The Analyzer suggested buying 960 shares of CSE at $10.23 per share for a total cost of $9,227, assuming $19.95 in commission charges (number of shares, in blocks of 100, and total cost after commission are calculated by the Analyzer, insuring that you do not go over the money available of $10,000. You can put any value into the money available field before running the Analyzer).

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 CSE as a good covered call candidate.  What this means is that you will be giving someone the right to purchase your stock (960 shares of CSE) at a predetermined price within a predetermined time and that person will give you some money 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 CSE.  The Analyzer selects stock/call combinations that have a strike price above the 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 CSE 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 purchase price and the out-of-the-money strike price. The call contract that was found had a strike price of $12.50 (out-of-the-money) with expiration on the third Friday of the next month (April 19, 2008) and selling for $0.75 per share (the call bid price or premium). What this means, is that there are investors who are willing to give you money ($0.75 per share) for the right to buy your CapitalSource, Inc. stock at $12.50 a share (the strike price) within the next 30 days (actually any time before April 19, 2008).   Because you paid $10.23 per share, which is lower than the strike price ($12.50), this is an out-of-the-money covered call transaction, meaning the stock price has to rise to $12.50 before it will be called away. You get the call price (premium) for selling the call contracts as well as possible appreciation of the stock share price to $12.50 before the shares of CSE would be called away.

You call your broker on Monday morning and buy 960 shares of CSE and sell 9 April12.5 (April $12.50) covered calls against your 960 shares of stock. Calls are traded in 100 share contracts, and the call contract symbol is CSEDV (the Analyzer determines this symbol for you). You receive $652 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 9 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 return of 7.1% ($652/$9,227) in 27 days and an annualized return of  about 96% on your investment of $9,227. 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 27 days until the option exercise date, April 19, 2008. 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 $12.50; or the stock price went above $12.50.

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 $652, and the person that bought the 9 calls (which are contracts between you, the seller, and the buyer) is not going to take the stock away from you at $12.50 because the stock price is less than $10.23 (the original purchase price). If the stock went down to $9.00, your loss would be $1,107 (-12%), but the sale of the calls offsets that loss by $652, resulting in a smaller loss of $455 (-5%).  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 $652 premium and the call contracts you sold cease to exist after April 19, 2008.

2. The stock price stayed the same. Your portfolio value stayed the same and you still have your stock and the $652. The person who bought the 9 calls is not going to exercise, because the stock price is still $10.23 and he/she is not going to give you $12.50 for each of your 900 shares. You realize a 96% annualized return on this 27 day investment and keep the stock.

3. The stock price went up, but not above $12.50. Your portfolio value went up, you still have the $652, and you get to keep your stock, because the person that bought the 9 calls isn’t going to pay you $12.50 for shares selling for less than that price. You realize more than 96% annualized return because the stock price has appreciated from the purchase price but not enough to lose the stock and you get to keep the $652 premium. The call contracts you sold ceases to exist after April 19, 2008. In case 1, 2, and 3 above, you may decide to sell 9 more out-of-the-money covered calls for the next month (May) and get some more premium, since you still own the stock.

4. The stock price went above $12.50. The person who holds the 9 calls exercises. That means he/she takes your 900 shares of CapitalSource, Inc. at $12.50 each. You had a gain of $2.27 on each share that you owned ($12.50 minus your cost of $10.23), or $2,043 for the 900 shares. But you must pay a commission on the sale (call) of your stock, assumed to be another $19.95, yielding a gain of $2,023. This, added to the $652 that you received for selling the 9 calls initially, yields a total return of $2,675 a real return of 29%, or an annualized return of 392%. Your money was invested for 27 days. Your $9,227 investment. became $11,902 (+29%) 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 purchase price and the strike price. CSE 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 $652 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 CapitalSource, Inc. stock went to $15.00 (which it didn't) you may be upset because you missed the ride. Don’t look back. Take your 392% annualized return, realized in 27 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 CapitalSource, Inc.? We bought the stock on Monday, March 24, 2008, for $10.64, costing $9,596 after commissions. It opened on that Monday at $10.56 and moved up throughout the day to close at $11.38. The low that day was $10.51. It closed at $10.23 on the previous Friday (March 21, 2008) and this price was used when the Analyzer was run on the weekend. The call bid price increased from $0.75 at the close on Friday to $0.80 on Monday morning since option prices tend to move in tandem with the stock price. After buying the stock, we sold the calls at $0.80 on Monday morning for $697 (900 X $0.80 - $9.95 - 9 X $1.50) after commissions. The market makers were right. As you can see from the chart below, the stock price moved lower for a few days, but then began a steady climb to $13.31 on April 18, 2008 (expiration). CSE closed above $12.50 on that day and the stock was called at $12.50 for each of our 900 shares. The stock appreciation was $1.86 or $1,654 for the 900 shares after commission on the sale of the called stock. This combined with the initial premium of $697 yielded $2,351 for a real return of 25%, 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 $9,596 produced a return of $11,946 (25%) in 27 days.

See where CSE is today