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An Introduction to Covered Calls

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By TMFHighYield
October 13, 2009

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RELATED TICKERS: INTC

Hi Fools,

It's been awhile since my last blog post for TMFHighYield, but I guess when your portfolio's strategy is to buy stocks with strong dividend yields and hold them indefinitely, well, there isn't much to say on a month to month basis.

Another reason for the lack of commentary is that over the past year I've been the analyst for our Motley Fool Pro service -- a $1m real money portfolio that uses stocks, ETFs, and options to go long and short the market with the ultimate objective of making money in all types of markets. This year, more than perhaps any other in the past fifty has presented quite a challenge. 

Income generation is one of the strategies we've relied on to deliver on our stated objectives -- not just from dividends but also from selling options (puts and calls). For income-focused investors like you (otherwise, you wouldn't be following HighYield, eh?), understanding how to sell options can help you not only augment your income returns but also improve price discipline. 

In a future installment, I'll discuss how to sell puts, but today I'd like to focus on arguably the most conservative type of income-based options trade -- the covered call.

When discussing options, I find that leading with an example is best.

Let's say that you bought 1,000 shares of Intel for $15 back in December 2008 (the same time it was added to the HY portfolio) -- a $15,000 investment for those of you playing at home. Now it's trading for $20, netting you a nice 33% gain in addition to the dividend income you've received the past 10 months.

Fine, you say, but with INTC trading at 16x forward P/E today, I'm not sure how much gas it has left to appreciate further. I'd also like some downside protection, just in case we're close a high here. 

This is a fantastic scenario for considering covered calls. For this example, we'll use the January 2010 $21 calls currently bidding $1.07 and asking $1.11. We'll also assume that you're selling 10 contracts against your 1000 shares.

When you write (or sell) a covered call, it means that for every call option you sell, you own 100 shares of the underlying stock (if you don't, it's a "naked" call and has a very different risk profile). For each option contract you sell, you are obligated to sell 100 shares of INTC at a certain price ($21) by a certain time (Jan. 15, 2010). In exchange for the risk (more on that in a second) you're assuming, the buyer of the call option pays you a cash premium ($1.07 per share), which is yours to keep no matter what happens.

So in the two good scenarios:

1.) INTC finishes at $20 a share on Jan. 15, 2010. You keep your 1000 shares and continue to generate dividends from them, plus you keep your $1,070 cash premium from the calls ($1.07 a share x 100 x 10) you wrote. You can turn around and write another covered call for more income.

2.) INTC finishes at $21.50 a share. Your 1000 shares are sold ("called away") at $21, but your net sale price is $22.07 -- $21 strike + $1.07 premium. You sell your $15,000 original investment for $21,000 and keep the $1,070 premium.

The not-so-good scenarios:

1.) INTC soars to $50. Your shares are sold for a net $22.07 and you can't enjoy the extra gains, but then again, you said you'd be happy to sell for $22.07 when you entered the contract, so c'est la vie. (Yes, CAPS options experts, you can "roll forward" or close the trade early if you change your mind, but for instructional purposes, we'll keep in simple here).

2.) INTC plunges to $5. The covered call expires worthless, you keep your 1500 shares and the premium received, but those 1000 shares are worth a lot less than they were before.

So if you couldn't guess it from the examples, here are the main risks to consider with covered calls:

1.) By agreeing to sell INTC at a certain price (the "strike" price) by a certain time, you are forgoing any upside to stock price beyond the strike. In other words, if your strike price is $21, you won't  benefit if the stock surges to $50 -- that upside now resides with the buyer of the call. So before you enter a covered call, you need to be content with the possibility that your stock could get sold.

2.) INTC's stock price could plunge between now and January 2010. Some things in the market you can't control, but if you think INTC is extremely overvalued and poised to plunge into the single digits, just consider selling it and cashing in your profits rather than hold on in exchange for $1.07 a share.

But on the whole, if you have a good understanding of the value of the underlying business (ie "INTC is worth between $18-$22) and are comfortable assuming the risks in exchange for a cash premium, covered calls are a great way for investors to augment their income gains, play defense, and seek higher sales prices.

Hopefully this overview of covered calls was helpful. Depending on the response, I'd like to continue this discussion of options strategies here on CAPS. Before you consider adding options strategies to your portfolio, I highly recommend learning more before jumping in.

The CBOE website is a great place to start.

And for the 198 of you who have made TMFHighYield one of your "favorite" CAPS players -- thank you for your continued support. 

Foolish best,

Todd Wenning (aka TMFPhila)

MF Pro analyst

(disclosure: I have no position in INTC)