Today is our fourth installment in a series of articles about stock options. We started with an introduction to options, and talked about buying options to protect stock positions; we next discussed options as outright leverage (perhaps their riskiest use); and third we discussed selling put options in order to earn income while waiting (and hoping) to get a lower share price on stock you want to buy.
Now we'll discuss what may be the most conservative use of options, and in the process we'll provide another reason why the bad rap typically rained down on options is unmerited. It's unmerited when you're an experienced investor using options smartly (and sparingly) with consistent, risk-aware (and therefore risk averse) strategies.
The strategy on the table today: Writing covered calls. What the heck does that mean? Simple, really.
Picking your sell price
When you write covered calls, you are selling "call" options on a stock that you already own. (Remember that "calls" give the owner the right to buy a stock at a certain price within a set time). Since you are writing -- or selling -- calls, you're giving the call buyer the right to buy a stock from you at a set price.
Why would you do this? You'd sell covered calls when you're ready to jettison a stock at a certain price that you believe is fair. In other words, you believe a stock is fully valued at a certain price. By selling calls with a strike price equal to your "full value" price, you guarantee that you'll sell your stock should it reach (or rise above) your desired price. Meanwhile, you'll generate income from the sale of the call option.
The best way to visualize this is with an example.
Shares of Intel (NASDAQ:INTC) have recently risen from $15 to above $20. You're smart. You bought at $15. Based on free cash flow estimates, you come to believe that the shares would be fully valued at $25, so you'd be willing to sell your shares at that price. You could just wait for your price, or you could sell call options and get paid while you wait for Intel to rise.
So, you look at Intel options and find that the January 2005 call with a $25 strike price sells for $2.20 per contract. You own 1,000 shares of Intel, so you sell 10 option contracts (each represents 100 shares) and you pocket $2,200 in income (minus commission and taxes). This payment adds about 9% to your gain in Intel should you eventually sell at $25. You'd in effect be selling at around $27.
But for now, you just wait and enjoy your $2,000. It's yours to keep no matter what. Eventually, there are three general outcomes:
1) Intel's stock fluctuates in a range between now and January 2005, ending up where it started, around $20. The call options that you sold -- which gave the buyer the right to buy Intel from you at $25 -- expire without being exercised. You were paid $2,000 and nothing else changed. You may wish to sell new calls on the stock after reassessing its value.
2) Intel tops expectations and soars 50% to $30. The option holder exercises his option and "calls" away your 1,000 Intel shares at $25. You've made $10,000 on the stock, plus about $2,000 for your option sale, meaning you sold at about $27. You missed an extra $3 per share (so far), but this assumes that you wouldn't have sold Intel when it hit your fair price of $25. That was your plan.
3) The chip slowdown continues and Intel is back to $15 by January 2005. Yeah, you could have sold it at $20, but you didn't want to; you wanted to sell at $25. That hasn't proven possible yet, but you did get about $2,000 while you waited for your price. You still own Intel and can choose your next move.
Clear caveats
Realize that you can still sell your stock once you've sold a covered call on it. Say that Intel disappoints and falls below $20 and you believe it's going lower. You want to sell. What you do is buy back the covered calls that you sold (they'll be priced lower now, so you'll profit on them) and then, having closed that out, you can sell your Intel position without worry. You're in the clear. (You don't want to sell calls -- or have an open position out there -- without owning the stock, because if the stock soars you'll need to buy it to deliver it to the option holder. Not good. Keep yourself "covered" -- own the stock.)
Second, it should be obvious that the share price you choose to sell at, and the option premium you're paid to write a covered call, are instrumental to using this strategy successfully. You don't want to be giving away your shares, via options, at ultimately inexpensive prices. And you don't want to forfeit upside potential for a marginal option premium payment.
You need a firm grasp on valuation if you're considering using options -- and even then you need to realize that you're likely to miss considerable upside sometimes when using covered calls. Investing in a good stock is a long-term endeavor. Options only last a few years.
Summary
We close with a summary of covered calls from our "Guide to Options" report:
Selling covered calls on stocks you already own at a price at which you've already determined to sell offers increased income in the event that the stock does not hit your sell target or declines in value. In addition, an investor can continue to "roll" the option over every time the option expires, thus earning continuous income on stocks that aren't showing strong positive moves. On the other hand, the investor is giving up some of the upside if the stock does better than expected -- but only if you wouldn't have sold at your pre-determined target price. Covered call options are, when properly utilized, a useful low risk/moderate reward strategy.
Best wishes to you...
Jeff Fischer owns shares of Intel in a dividend reinvestment plan. He doesn't own any covered calls currently, although he does coerce cat calls. The Fool has a full disclosure policy.
