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Covered Call

 

 

Description

 

Writing a Collar Covered Call is the most basic of income strategies, it is very effective, and can be used by novices and experts alike.

 

The concept is that in owning the stock, you then sell an Out of the Money call

option on a monthly basis as a means of collecting rent (or a dividend) while you

own the stock.

 

If the stock rises above the call strike, you will be exercised and the stock will be sold. But you make a profit anyway. (You are covered because you own the stock

in the first place).

 

If the stock remains static, then you are better off because you collected the call premium. If the stock falls, you have the cushion of the call premium you collected.

 

On occasion, it is attractive to sell an In the Money or At the Money call while you

already own the stock. In such cases, the premium you collect will he higher, as will

the likelihood of exercise, meaning you will  end up delivering the stock at the strike price of the sold call.

 

Market Opinion

 

With a Covered Call, your outlook is neutral to bullish. You expect a steady rise.

 

P/L Profile

 

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When To Use

 

This option is an income strategy.

       

 Example

 

     1.  Buy (or own) the stock.

 

     2.  Sell calls one or two strike prices out of the money  (i.e., calls with strike

         prices one or two strikes price higher than the stock).

 

         If the stock is purchased simultaneously with writing the call contract, the

         strategy is commonly referred to as a "buy-write".

 

         Generally, only sell the calls on a monthly basis. In this way you will cap-

         ture more in premiums over several months, provided you are not exer-

         cised. Selling premium every month will net you more over a period of

         time than selling premium a long way out. Remember that whenever you                 

         are selling options premium time decay works in your favor. Time decay is

         at its fastest rate in the last 20 trading days (i.e. the last month), so when

         you sell option premiums, it is best to sell them with a month left, and do it

         again the following month.

 

         Remember that your maximum gain is capped when the stock reaches the

         level of the callís strike price.

 

         If trading U.S. stocks and options, you will be required to buy (or be long

         in) 100 shares for every options contract that you sell.

 

         XXXX is trading at $28.20 on February 25, 2011.

 

         Buy the stock for $28.20.

 

         Sell the March 30, 2011 strike call for $0.90.

    

         You pay: Stock price - call premium. $28.20 - 0.90 = $27.30

 

For a collar covered call, also buy a put option to cover your downside risk. The yield would be less, but you would be protecting your position on the downside.

 

Benefit

 

Investor is able to accrue monthly income on the underlying stock, plus has reduced risk compared to simply owning the stock.

 

Risk vs. Reward

 

The risk is that you lose the stock price minus the call premium. The reward is the call premium you received plus the call strike less the stock price paid.

 

Net Upside

 

A good income percentage return.

 

Net Downside

 

Loss of the price of your stock minus the call premium. Capped upside potential if the stock rises.

 

Break Even Point

 

Stock price minus call premium received.

 

Effect Of Volatility

 

N/A

 

Effect Of Time Decay

 

Positive effect. It eats into the value of the call sold. If the stock does not hit the strike price, you have reduced your original cost of buying the stock with the option premium you received.

 

Alternatives Before Expiration

 

If the stock falls below your stop loss, then either sell the stock (if you are

approved for naked call writing) or reverse the entire position (the call will be cheap to buy back).

 

Alternatives After Expiration

 

If the stock closes above the strike at expiration, you will be exercised. You

will deliver the stock at the strike price, while having profited from both the option premium you received and the uplift in stock price to reach the strike price. Exercise is automatic.

 

If the stock remains below the strike but above your stop loss, let the call

expire worthless and keep the entire premium. If you like, you can then write another call for the following month.

 
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