The DOW appears set to test its November low over the next few sessions. Investor sentiment in stocks continues to be extremely bearish, with upside m...
The DOW appears set to test its November low over the next few sessions. Investor sentiment in stocks continues to be extremely bearish,
with upside moves vulnerable to selling.
Are you nervous about the downside risk and having bouts of insomnia? Should you sell? For investors familiar with option strategies, there is a simple solution to help safeguard a long position, while at the same time generating some income.
Within options trading, you may want to take a look at a strategy known as "covered call writing." In a market with limited upside, this strategy is simple to conceptualize and makes a lot of sense.
In this editorial, I will only focus on covered call writing, which involves the simultaneous ownership of the underlying stock and writing an equivalent number of call option contracts. This strategy is geared to the investor who doesn't mind holding the underlying stock. Investors employing this strategy are either neutral or bearish.
By "writing a call," the investor would sell the call option in the market. By doing so, the writer is obligated to deliver the underlying security at a predetermined price also known as the "exercise" or "strike" price. Each option contract represents 100 units of the underlying security.
Say you own 100 shares of Intel Corp. (NASDAQ/INTC) and believe that the stock is stuck in a range. You can generate some premium income via writing a call on your position. In return, you, as the writer of a call option contract, are legally responsible to deliver 100 shares of Intel at the exercise price to the buyer of the call option if exercised. Each option contract has an associated expiry month, with the option expiring on the Friday prior to the third Saturday of March or whatever month is specified. If the option is not exercised by this date, it is said to expire worthless.
In some cases where the writer (the seller of the option) wants to close out the option prior to the exercise date, buying the same number of calls on the same security would be enough to eliminate the original obligation.
So why use a covered call writing strategy? There are three key reasons. The writer reduces the risk of holding Intel. Say Intel drops in price, the writer would offset a portion of the loss of the long position by the premiums paid by the buyer of the Intel call.
This premium is the income generated by the writer, which is the second major reason for a covered call strategy.
The final reason is that the writer can predetermine a price at which Intel would be sold; thereby guaranteeing a selling price.
Let's take a look at how this would work. An investor writing one Intel April $15 call option under a covered strategy is obligated to sell to the buyer upon exercise 100 shares of the stock at $15.00 per share (strike price). For assuming the risk of exercise, the writer of this particular Intel call option receives a premium of $71.00 per contract ($0.71 per share x 100 shares).
The "covered" in the strategy means that the writer holds 100 shares of Intel. Upon exercise, these shares would be delivered to the buyer of the call option at the strike price. By being long in the stock, the upside risk of the call options is hedged.
The writer guarantees a selling price of $15.00 for the Intel shares. However, the writer will miss out on any gains above $15.00 by the April 17 expiry.
For the covered call writer, the maximum risk is the cost of the underlying stock (what you paid for Intel) less the premium received. This is the case when the stock moves to zero.
The maximum reward is the difference between what you paid for the stock and the strike price plus the premiums received.
Take a look at your holdings; perhaps there are some opportunities for you to generate some premium income.
Profit Confidential
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