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Who Should Consider Using Covered Calls? An investor who is neutral to moderately bullish on some of the equities in his portfolio. An investor who is willing to limit his upside potential in exchange for some downside protection. An investor who would like to be paid for assuming the obligation of selling a particular stock at a specified price. This strategy would work equally well for a cash, margin, Keogh account or IRA. Although this strategy may not be suitable for everyone, any of the investors above may benefit from using the covered call. Definition Covered call writing is either the simultaneous purchase of stock and the sale of a call option or the sale of a call option against a stock currently held by an investor. Generally, one call option is sold for every 100 shares of stock. The writer receives cash for selling the call but will be obligated to sell the stock at the strike price of the call if the call is assigned to his account. In other words, an investor is "paid" to agree to sell his holdings at a certain level (the strike price). In exchange for being paid, the investor gives up any increase in the stock above the strike price. How to Use Covered Calls If an investor is neutral to moderately bullish on a stock currently owned, the coved call might be a strategy he would consider. Let s say that 100 shares are currently held in his account. If the investor was to sell one slightly out-of-the-money call, he would be paid a premium to be obligated to sell the stock at a predetermined price, the strike price. In addition to receiving the premium, the investor would also continue to receive the dividends (if any) as long as he still owns the stock. The covered call can also be used if the investor is considering buying a stock on which he is moderately bullish for the near term. A call could be sold at the same time the stock is purchased. The premium collected reduces the effective cost of the stock and he will continue to collect dividends (if any) for as long as the stock is held.
In either case the investor is at risk of losing the stock if it rises above the strike price. Remember, in exchange for receiving the premium for having sold the calls, the investor is obligated to sell the stock. However, as you will see in the following example, even though he has given up some upside potential there can still be a good return on the investment. Stock ZYX currently is priced at 41.75, and the investor thinks this might be a good purchase. The threemonth 45 calls can be sold for 1.25. Historically, ZYX has paid a quarterly dividend of 25 cents. By selling the three-month 45 call the investor is agreeing to sell ZYX at 45 should the owner of the call decide to exercise his right to buy the stock. Keep in mind that the call owner may exercise the option if the stock is above 45, because he will be able to buy the stock for less than it is currently trading for in the open market. But, as you will see, his return will be greater than if he had held the stock until it reached 45 and then sold it at that price. Let s take a look at what happens to a covered call position as the underlying stock moves up or down. Commissions have not been taken into consideration in these examples; however, they can have a significant effect on your returns. Buying 100 ZYX at 41.75 and Selling 1 Three-Month 45 Call at 1.25 I. ZYX remains below 45 between now and expiration--call not assigned. The call option will expire worthless. The premium of 1.25 and the stock position will be retained. In effect you have paid 40.50 (which is also the breakeven price) for ZYX (41.75 purchase cost - 1.25 premium received for sale of call). This would be offset by any dividends that were received, which in this example would be 25. When the ZYX call expires worthless, the covered call writer can sell another call going further out in time taking in additional premium. Once again, this produces an even lower purchase cost or breakeven. If ZYX remains below 45 for an entire year, the investor can sell these calls four times. For this example we will make the hypothetical assumption that the price of the stock and option premiums remain constant throughout the year. 1.25 (Call Premium Received) x 4 = $5 in Premium + Any Dividends Paid = Total Income.
II. ZYX rises above 45 between now and expiration--call assigned. The call buyer can exercise his right to buy the stock and the call seller will have to sell ZYX at 45, even though ZYX has risen above 45. But remember the call seller has taken in the premium of the call and has been earning dividends (if any) on the stock. If ZYX stock is called away at expiration: Receive: $45 for Stock $4,500.00 Less: Net Investment (Stock Cost - Premium Received) [$4,175 - $125] ($4,050) Return: 11.11% $450* *In three months plus dividends (if any) received. III. ZYX is right at 45 at expiration. The seller of a call may be in situation I or II. The stock may be called away and the call writer will be obligated to sell ZYX at 45. Alternatively, the stock may not be called away. A call could then be sold going further out in time, bringing in additional premium and further reducing the breakeven point. Summary The covered call write is a strategy that has the ability to meet the needs of a wide range of investors. It can be used in your Keogh, margin, cash account or IRA against stock you already own or are planning on buying. Currently, there are short-term options listed on more than 1,400 stocks and more than 350 of those stocks also have LEAPS, Long-term Equity AnticiPation Securities TM, which are simply long-term stock and index options. Today s investor has a choice of short-term and long-term expirations, as well as multiple strike prices. This strategy is actually more conservative than just buying stock, due to the fact that you have taken in premium and lowered your breakeven price on the stock position. The covered write allows you to be paid for assuming the obligation of selling a particular stock at a specified price.
FREE interactive strategies are available at www.cboe.com Options involve risks and are not suitable for all investors. Prior to buying or selling options, an investor must receive a copy of Characteristics and Risks of Standardized Options. Copies may be obtained by contacting your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation at www.theocc.com. In order to simplify the computations, commissions, dividends, fees, margin interest and taxes have not been included in the examples used in this document. These costs will impact the outcome of stock and options transactions and must be considered prior to entering into any transactions. Investors should consult their tax advisor about any potential tax consequences. The strategy discussed above is strictly for illustrative and educational purposes only and is not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. LEAPS is a registered trademark and Long-term Equity AnticiPation Securities SM is a service mark of Chicago Board Options Exchange, Incorporated (CBOE). Copyright 2012 CBOE. All rights reserved.
Who Should Consider Selling Cash-Secured Puts? An investor who would like to acquire a position in a particular security, but is willing to wait for it to trade at his desired purchase price. Have you given your stockbroker an order to buy a security at a specified price? If you have, you have participated in a waiting game. The stock will not be purchased until it trades at or below your limit price. Instead of waiting for that to happen, you could have sold a cash-secured put. A premium (the price of the option) for selling a put option would be paid to you for accepting the obligation to buy a stock that you want to be a part of your portfolio at the price you select. This strategy is used by large portfolio managers as well as individual investors because it pays them for assuming the obligation to buy a particular stock. In other words, certain investors who are considering buying a stock (or more of a stock they already own) may want to sell cash-secured puts. Definition Selling a cash-secured put involves selling a put and depositing the money for the purchase of stock at the brokerage firm (generally, this money is invested in short-term instruments). The purpose of having the money in the account is to assure that funds are available to purchase the stock should the put be assigned to the account. Generally, the buyer of the put will exercise the option should the underlying stock drop below the strike price (the price at which the seller of the put has agreed to buy the stock). If the stock does not drop below the strike price by expiration, the premium will be retained by the seller and another put may be sold. By selling the put, the investor receives the premium while waiting for the stock to decline to the strike or price at which he is willing to own it. Therefore, the cash-secured put is a strategy that may help you accumulate stock at a lower price than where it is currently trading (net cost = strike price - premium). How to Use the Cash-Secured Put to Buy Stock at a Lower Price Stock ZYX is a stock that an investor would like to own. Currently, it is priced at 47-1/8, but he feels it would be a good buy at 45 and that the stock could reach that level within the next two months. The investor can either place a limit order to buy ZYX at 45 or an order to sell ZYX puts with a 45 strike. Remember, by selling the puts with a 45 strike, he has the obligation to buy the stock at 45 should the buyer of the options exercise the right to sell ZYX. The investor would sell one put for every 100 shares of stock he was willing to purchase..
Let s compare these two strategies. Commissions and taxes have not been taken into consideration in these examples, although they can have a significant affect on your returns. Placing a Limit Buy Order on 500 ZYX at 45 vs. Selling 5 ZYX 2-Month 45 Puts at 1.25 When the Stock is Trading at 47. At expiration, the stock will either be above 45, in which case the investor will not buy the stock, or below 45, in which case he can expect to buy the stock at 45. The outcome of each scenario is explained below. I. ZYX remains above 45 between now and expiration--option not assigned. Limit Order to Buy 500 ZYX @ 45 Sell 5 ZYX 2-month 45 Puts @ 1.25 no stock is bought no stock is bought limit order still open keep premium of 1.25 x 5 contracts = $625 By selling a cash-secured put or entering a limit order to purchase the stock, the investor will not be able to participate in a rise in the price of the underlying. If the puts that were sold expired without being assigned, the investor could sell another 5 puts if he were still interested in owning 500 shares of ZYX. II. ZYX is below 45 at expiration--option assigned. Limit Order to Buy 500 ZYX @ 45 Sell 5 ZYX 2-month 45 Puts @ 1.25 Own (long) 500 shares ZYX @ 45 Own (long) 500 shares ZYX @ 45-1/4 less premium for put 41.25 net cost = 43.75 Using a limit order to buy ZYX, the breakeven would be what he paid for the stock. Selling the put lowers the breakeven which is the strike price less the premium, 45-1.25 = 43.75. Having sold the puts with a 45 strike, should ZYX decline considerably the investor still has the obligation to buy the stock at 45. However, he does have the cost reduction of the 1.25 premium received for the sale. If a limit order had been used to purchase the stock at 45, he would begin losing money as soon as ZYX dropped below 45 (the breakeven). III. ZYX is at 45 at expiration. The investor may be in either situation I or II. With a limit order at 45, he may or may not buy the stock. There is no guarantee that he has bought ZYX at 45 until it trades below his limit price. If puts were sold, he has the obligation to buy 500 shares of ZYX, and he may be assigned (have the stock put to him ) or the puts may expire worthless. Either way he retains the premium. Placing a Limit Buy Order on 500 ZYX at 60 vs. Selling 5 ZYX 2-Month 65 Puts at 5.50 When the Stock is Trading at 65 There is another way to use the cash-secured put. For this example we will assume ZYX is trading at 65. Once again, an investor would like to own ZYX, but not at this level. He thinks that ZYX would be a good buy at 60. The previous example showed the sale of an out-of-the-money put (put strike price below current stock price) which required the stock dropping to the strike price of the put before the stock would be purchased. An alternative approach is to sell an at-the-money put (put strike price and current stock price are equal) or an in-the-money put (put strike price above current stock price) in which the premium from the put assures a target net purchase price
for the stock. By selling an in-the-money put it is more likely that the put will be assigned and the stock will be purchased. The owner of an in-the-money put is likely to exercise his right to sell the stock above its current value, therefore, the seller of the put will be obligated to buy the stock. Let s compare the limit order to the at-the-money put sale. I. ZYX rises above 65 between now and expiration, and there is no assignment. Limit Order to Buy 500 ZYX @ 60 Sell 5 ZYX 2-month 65 puts @ 5.50 no stock bought no stock bought limit order still open keep premium of 5.50 x 5 contracts = $2,750 II. ZYX drops below 65, but remains above 60 by expiration--option assigned. Limit Order to Buy 500 ZYX @ 60 Sell 5 ZYX 2-month 65 puts @ 5.50 no stock bought own (long) 500 shares ZYX @ 65 limit order still open less premium for put 65.50 net cost = 59.50 Selling the cash-secured put at a strike price of 65 for 5-5/8 allowed the investor to buy ZYX below the 60 limit at a net cost of 59.50, even though ZYX never traded there. If he had used a buy order at 60, he would not own any stock. III. ZYX drops below 60 by expiration--option assigned. Limit Order to Buy 500 ZYX @ 60 Sell 5 ZYX 2-month 65 puts @ 5-5/8 own (long) 500 shares @ 60 own (long) 500 shares @ 65 less premium for put 65-5/8 net cost = 59-3/8 Even if ZYX dropped through his 60 limit, the cash-secured puts supplied some downside protection. Since the net cost is 59-3/8, so is the breakeven. Had ZYX been purchased with a limit order at 60, the investor would not have any downside protection, and would begin to lose as soon as it dropped below the limit order cost. IV. ZYX at 60 at expiration. If a limit order was used to buy the stock, he may or may not own it. However, had the put been sold he might be put the stock and own ZYX at a price of 59.50 (65 strike price - 5.50 premium). Summary Selling a cash-secured put is a strategy that allows you to be paid a premium for the obligation to buy a particular stock. Currently, there are short-term options listed on more than 1400 stocks and more than 350 of those stocks also have LEAPS, Long-term Equity AnticiPation Securities TM, which are simply long-term stock and index options. The premium received for selling a put gives you some downside protection by lowering your breakeven while placing no limit on how high the stock can be subsequently sold. This strategy may also give you the opportunity to purchase a security for a lower cost than it is currently trading. In other words, someone interested in investing in stock may want to consider selling a cash-secured put as a means of buying that stock.
FREE interactive strategies are available at www.cboe.com Options involve risks and are not suitable for all investors. Prior to buying or selling options, an investor must receive a copy of Characteristics and Risks of Standardized Options. Copies may be obtained by contacting your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation at www.theocc.com. In order to simplify the computations, commissions, dividends, fees, margin interest and taxes have not been included in the examples used in this document. These costs will impact the outcome of stock and options transactions and must be considered prior to entering into any transactions. Investors should consult their tax advisor about any potential tax consequences. The strategy discussed above is strictly for illustrative and educational purposes only and is not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. LEAPS is a registered trademark and Long-term Equity AnticiPation Securities SM is a service mark of Chicago Board Options Exchange, Incorporated (CBOE). Copyright 2012 CBOE. All rights reserved.