Saturday, January 27, 2007

A Bullish Strategy and a Bearish Strategy Using Calls

Last week I wrote a little about calls. I defined them and showed how they could be used in place of a stock to try to profit on a rising stock. The article generated quite a lot of interest so this week, I'll address another bullish strategy using calls.

This strategy is bullish and is one of the more common uses of call options. It is known as writing covered calls. In stock lingo writing means selling. Covered means you own the underlying stock, and you already know what a call is from last weekend's article.

Let's use an example that existed during the past week. When NYSE Group (NYX) was trading around $62.90, the Jul 60 calls were trading at $4.50 x $4.80 while the Jul 65 calls were trading at $1.95 x $2.10. If we're going to write covered calls, we need to own at least 100 shares of the stock since a single option contract controls 100 shares of stock.

In case you are unfamiliar with option quotes, you'll see that there are two prices, the bid and the ask. The bid (lower number) is what someone (often the market maker) is willing to pay for the option and the ask (higher price) is the price at which someone (often the same market maker) is willing to sell the option. The difference between the bid and the ask prices is called the spread. In our example on NYX, you can see that the spread on the July 60's is 30¢ and the spread on the 65's is only 15¢.

Back to covered calls. Suppose it looked like NYX was moving up. We could buy the stock for $62.90 a share and simultaneously sell calls against the stock (known as a buy/write when we do both at the same time). Suppose we decided the stock looked very strong and we decided to buy the stock at $62.90 and simultaneously sell the Jul 65 calls for $1.95. Since option contracts usually control 100 shares of stock, we would have to buy at least 100 shares of stock to sell 1 contract of call options. In this case, let's say we decided to buy 100 shares of the stock for $6,290 and sell 1 contract of the July 65 calls for $195 (100 shares x $1.95) our net debit would be $60.95 ($62.90 minus $1.95) so we would only have $6095 out of pocket since the market is giving us $1.95 a share for the calls. Now what is the situation? Well, we own 100 shares of NYX, but since we sold the Jul 65 calls, we are obligated to sell our stock at $65 a share if called anytime before July expiration. Since the stock price is less than the strike price of the call we sold, we sold an "out of the money" call in this example. If the stock doesn't get above $65 before expiration what happens? Well, we get to keep the stock because no one is going to pay us $65 a share if they can buy it cheaper on the open market, and we also get to keep the $1.95 a share premium we got for selling the call. What if the stock is more than $65 at expiration? Well, we'll most likely get called out (assigned) since the call buyer can now buy the stock from us for $65 and immediately turn around and sell it for whatever price the market is then paying. Of course, we still got to keep the $1.95 a share call premium AND, we have sold a stock we bought at $62.90 for $65 thus adding another $2.10 a share to our profit. If we don't get called out, we made $1.95 a share on our $62.90 stock or about 3% for less than a month. If we do get called out, we make the $1.95 premium PLUS the $2.10 a share profit for a return of about 6.4% for less than a month. Of course, commissions are paid on the transactions so we need to be aware of that cost.

Instead of selling the "out of the money" call, we could have chosen to sell an "in the money" call. For example, with NYX at $62.90, we could have bought the stock and simultaneously sold the Jul 60 call for $4.50 a share. Now, our out of pocket would be $62.90 - $4.50 = $58.40 or $5840 for the 100 shares. Suppose the stock stays above 60 (the strike we sold) to expiration. Well, we'd be called out at $60 a share, wouldn't we? But we paid $62.90 a share so we're going to lose $2.90 a share. So what, the market gave us $4.50 to sell the call and now, we're only giving back $2.90 of that $4.50. We KEEP $1.60 a share even if the stock drops almost $3 from where we bought it. That's less than a one month return of 2.5%!

Buying stock is always risky. The risk is what we pay for the stock because theoretically, at least, the stock could go to zero. So, when we buy a stock and also sell a covered call, our risk is always less than it is if we bought the stock alone. The market has paid us to sell the call and our risk is reduced by that amount. Some traders and investors sell calls against their portfolio quite regularly and can thereby enjoy reduced risk and a monthly return on their investment. Of course, if we sell a covered call, we are obligated to sell the stock at the strike price we sold. In our example, suppose NYX went to $100 a share and we had sold the 60 call. Unless we had taken some action to buy back our call, we'd have to sell the stock at 60 if called (and we certainly would be). So, when we sell covered calls, we are giving up some opportunity to the up side if the stock runs. If we're afraid to lose that chance, writing covered calls isn't for us. If we want to reduce risk and create monthly income, it is a strategy worth learning.

Bill Kraft, Editor P.S. Bloggers! Subscribe to my Trend Trader Service at and use this link for $50 PER MONTH SAVINGS!. P.S. Bloggers! Subscribe to my Under $10 Stock Trader Service at and use this link for $50 PER MONTH SAVINGS! P.S. Bloggers! Subscribe to my Option Trader Service at and use this link for $50 PER MONTH SAVINGS!.

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