Credit/Credit Spread Strategy:
Covered Calls

AKA: Buy-Write

ANALOGY/METAPHOR: Being a Stock Landlord/Leasing out Your Own Shares

ACTION: For each 100 shares of stock you own, sell (or write) 1 out of the money (OTM) call option. [note: more conservative approaches involve writing the call at the money (ATM) or even in the money (ITM).] In exchange for the premium received, you give the purchaser of the option the right to purchase your 100 shares at any time up to and including expiration at the strike price of the call option.

DESCRIPTION: Writing covered calls is a basic, popular, and generally conservative income-producing option trading strategy. I really like the landlord analogy. The premium received is equivalent to rental income. But with this strategy, comes an added twist - your tenant has the right to purchase the property outright from you at a predetermined price (i.e. the strike price of the call option you sold or wrote).

As long as the call option expires OTM, your stock is safe and you can repeat the process again and again. Even if the stock does close a little higher than the strike price, you can always roll out the position, buying back the current call and selling another one the next month out at the same strike price (or possibly at a slightly higher strike price), and collecting additional premium. If the stock continues to rise, it will eventually no longer be cost effective to roll out the position. You can quickly find yourself having to roll it out a year or two in the future just trying to keep the position alive.

And therein lies the greatest risk of the covered call strategy--the loss of potential large capital gains when the stock you own moves up in a big way. The premium you receive is great when the stock is flat, and it even adds some downside protection if the stock begins to trend lower (you can calculate your stock position's adjusted cost basis as your original purchase price less the options premium received). But if the stock ever explodes higher, you'll be left far behind.

EXAMPLE: The XYZ Zipper Company is trading at $33.50/share. Although the stock has shown a fair degree of volatility in the past, you feel that it's fairly valued and you don't expect it to move much higher anytime soon. You're also planning a vacation to somewhere special like the Cadillac Ranch, Dollywood, or that big-ass statue of Paul Bunyan in Bangor, Maine, and you wouldn't mind generating some extra cash for the trip.

You already own 100 shares of XYZ (and let's assume you purchased it at its current value), and you decide to sell a $35 call option that expires in one month. The option premium is going for $1. Excluding commissions (in the Land of Examples it's always sunny), you pocket an even $100. As long as the stock stays below $35/share, the premium received is yours free and clear, and the underlying stock remains in your possession.

But let's look at some other possible outcomes:

1. The FDA unexpectedly approves The XYZ Zipper Company's controversial Medical Zipper device for general surgical use and the stock jumps to $45/share. The good news is that you're not going to lose any money. The bad news is that you miss out on all the capital gains above $35/share. The premium is yours to keep as well as all profits up to $35/share. Your net gain per share then is $2.50/share ($35/share price less the original purchase price of $33.50/share plus the $1 call option premium received when you sold the covered call).

2. As you anticipated, the stock goes nowhere and closes at expiration at $33.50/share. - Well played. Buy and hold got you nowhere, so you look pretty smart selling the covered call. Depending on how you prefer to calculate it, you either gave yourself an approximate 3% special dividend or you lowered your cost basis in the position by a buck.

3. The CEO of The XYZ Zipper Company is arrested on drug, prostitution, and weapons charges and the stock plummets to $13/share. Whoops. You really wish now that you'd invested in a conservative button manufacturer like your hair stylist advised you to. The only positive development is that $100 premium you received from writing the covered call - that's yours to keep.

VARIATIONS: The primary variable is the strike price at which you write the covered call. Essentially, you have three choices, with three sets of implications:

OTM = premium income + potential capital appreciation + limited downside protection

ATM = maximizes premium income + no potential for capital appreciation + slightly better downside protection

ITM = premium income (less the amount the option is in the money) + no potential capital appreciation + moderate downside protection. [note: this is the most conservative approach to writing covered calls - the profit potential is less but the likelihood of success is the greatest of the three.]

Finally, there are long term investing (vs. short term trading) uses of the covered call approach. These are part of what I term (and advocate), Leveraged Investing. These include: The 1/3 Covered Call Writing Strategy, LEAP Bull Call Spread, and LEAP Covered Calls.

OTHER: Writing covered calls is often portrayed as a means to generate monthly income. In my experience, however, it's difficult to combine high yield returns with monthly consistency. I've found that overall success is easier to achieve if you can liberate yourself from the monthly mindset. Writing covered calls from two to six months out gives you more flexibility and wiggle room to be right. Whether you're writing OTM, ATM. or ITM calls, the additional premium available from these farther out months gives you more downside protection and overall profit potential. On an annualized basis, and on paper, writing monthly calls, will look a lot better than writing quarterly calls, but the reality is that any stock with a decent premium, isn't going to stay in a well-behaved trading range month in and month out.

Also, a quick summary of the alternative name for this strategy: Buy-Write. The description and examples above all assumed that you were a current and/or longstanding owner of the underlying stock. The buy-write strategy involves simultaneously purchasing stock and writing calls on that stock.

There's a subtle but important difference then between writing covered calls and employing the buy-write strategy. The first is a stock owner looking to generate additional income from his or her holding. The second is an options seller who only buys the stock out of necessity in order to execute the strategy.