A Basic Covered Calls Strategy


Let me start by saying that you can lose money with this covered calls strategy, as you can with any investment strategy. No promises here, just an interesting technique that investors have used to make money... and sometimes to lose it. (And I do not personally use this strategy to make money.)

Options can be confusing, so I'll explain only the basic call option. It is a contract that gives the holder the right--but not the obligation--to buy a 100 shares of a stock at a set price (the "strike price") by a set date, the latter being the third Friday of whatever month is specified. Let's look at a specific example. It is December 3, 2010 today, and FirstEnergy Corporation (FE) stock closed at 35.63 per share. Looking down the list of the many different options available to buy or sell, I see this: Jan 37.50 0.35. That means a January call option with a strike price of $37.50 sells for 35 cents per share, or $35 per contract (which covers 100 shares). It expires on January 21 (the third Friday). If the price of the stock is higher that $37.50 by then, it is likely that the option will be exercised, meaning the holder will buy those shares for $37.50 each, or $3,750 for the 100 represented by each contract.

Because the strike price is above the current price, this is called an "out of the money" option. Historically, most of these expire worthless. That's part of the reason we might want to be on the selling end. Now, if you just went out and sold ten of those options without owning the stock, they would be "naked calls." Your broker might allow this if you have a lot of money and experience. You would get $350 deposited into your account, minus about $15 in commission. If the price didn't go above $37.50 in the next six weeks, you made an easy profit.

This is risky, of course, Suppose the stock goes to $50 by January, and you have to sell 1,000 shares (10 contracts times 100 shares) at $37.50. You'll have to first buy them at $50, so you'll lose a total of more than $12,000.

Selling covered calls, by contrast, is less risky. You own the stock you sell the calls on. So, to return to the example above, lets say you bought those 1,000 shares of FirstEnergy Corporation at today's price of 35.63 per share. You like the future of the company and you like the 6.3% dividend yield. But you want to make even more with your stock, so you sell ten January 37.50 calls and collect the $335 you get after the commission. Now if the price rises to $50, you will miss out on most of it, but because you bought at 35.63, you'll still make about $1,360 when you are forced to sell for $37.50, plus the $335 you already made. Not bad, and if the price stays about the same, you keep selling options every month or two when the old ones expire, perhaps generating an extra 5% annually on top of the dividends, making over 11% even if the price is the same a year from now.

Now to that Covered Calls Strategy

Okay, the above is an example of one strategy, which is to sell call option to boost incomes from stocks you own. I used it to explain the basics of call options. The ones described, by the way, are what's called "out of the money" calls, because the strike price is above the current price. Now we're going to look at buying low-priced stocks and selling "in the money" calls as a way to lower risk while making short term gains.

"In the money" means the stock is already higher than the strike price of the call option. For example, Microsoft (MSFT) closed at 27.02 today, and among the many options you could sell is a January 24 at 3.20 ($320 per contract). Why would you want to do that. You wouldn't, in this case. But there are times when you can get quite a bit for a call option that is in the money, and if you just bought that stock you can effectively lower your price while potentially making a fast profit. Let's look at very specific examples, again using today's (12/03/10) real prices.

Orexigen Therapeutics, Inc. (OREX) closed at $4.81 today. Lets say you bought 1,000 shares at that price, for a total of $4,815 including a discount broker commission. December 4 calls have a bid of $1.70, so you sell 10 contracts and get $1,700, or $1,688 after the commission ($4.95 plus .65 per contract at my broker). Now lets look at what you've done and what might happen. Since you immediately recouped $1,688 of your $4,815, you have only $3,127 at risk. If the stock stays above $4 the holder of the options will exercise them, paying you $4,000, so you'll get about $3,950 after the commission. That means you make $823, having invested only $3,127. Did I mention that these options expire December 17? Your 26% return is made in two weeks.

Of course the stock could plummet and you could lose most of your money. This is true of any stock. But remember that it has to fall a ways before you lose. You just collected $823, cutting your net cost to $3.99 per share after all commissions. Now, suppose it did fall to $3.50 per share, so the options expired worthless. You could hold on, and if it climbs anywhere above $4 you can sell for a profit. Even though you bought at $4.81 you would be ahead selling at $4.31 thanks to the option money you collected.

Note: Of course the stock could go to zero, in which case you lost $3,127--everything.

To reduce your risk and still have the opportunity to make a return of 5% or more per month, this works best with low-priced stocks and in-the-money call options. Usually, the companies whose options have such steep premiums are about to announce big news, either good or bad, so the stock price is likely to move quite a bit. If it's a big move down you can lose money. If it is a big move up you can miss out on most of it since your stock will be "called away" when the holder of the options forces you to sell at the lower price.

So the basic covered calls strategy here is to count on the stock being called away and make your profit on the options. Otherwise you can dump the stock just after the options expire, taking your loss, or holding for a bounce back to make a small gain.

How Much Can You Make?

This is a real example, but an extreme one. There are many opportunities every month for making 5% in a few weeks, and there is a site in the resource section below that finds these for you. There are no guarantees and no way to say what your results will be--you might even lose everything if you aren't careful (or even if you are). But assuming you find some of the safer bets and can average 4% per month on your investments and keep half of your money invested at any given time, you can make a total return of 24% annually, which doubles your money every three years or so. At that rate $40,000 becomes $320,000 in nine years.

Ways to Make More | Related Opportunities | Tips

You will sometimes have the opportunity to "capture" a dividend to make even more money. For example, if you buy the stock a few days before the ex-dividend date and own it on that date, you'll get the payout even if you sell the stocks before the actual pay date. Thus, you might buy a stock, collect for the call options and the dividend, and so dramatically reduce your cost of ownership, and so your risk.

Qualifications / Requirements

Brokers generally require you to have some experience and to sign a form acknowledging the risks before they'll allow you to sell options.

First Steps

If you don't already have an account with a discount broker, open one. You need to keep transaction costs down with options or you can easily pay out half of your gains in commissions.


http://www.optionsbuddy.com - There is a covered call screener here that points out which stocks have the most expensive calls--perfect for this covered calls strategy.

http://finance.yahoo.com - Great resource for stock prices, information, and you can just click the options button to get lists of all the options you can sell on a given stock.

http://www.tradeking.com - This is one of the cheaper brokers, and I like their service.

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