Covered Calls

[Uncle Max]

SPECULATORS HAVE AN AIR OF ROMANTICISM about them. The good ones are intellectual adventurers seeking profits when the crowd is indecisive, afraid, or too confident.

Corporate earnings reports always attract speculators, many of whom use options contracts because they can risk a little bit of money and make a high return should the news prove right the speculation. Now, as many stock prices are settling down after rallying on earnings, it makes sense to look for stocks that might have limited upsides, but rich options premiums.

This can be done using a classic strategy known as covered-call writing that entails buying stock, and simultaneously selling a call option. This strategy is attractive to many investors and traders because it reduces the cost of buying stock by the amount of money received from selling the call. The trade-off for buying stock below its market price is that you are obligated to sell the stock if its price exceeds the options' strike price.

Let's use Mankind (MNKD) to demonstrate how this strategy works, and how it is possible to conservatively speculate on stock prices. Oppenheimer & Co. has a buy rating on the biopharmaceutical stock and a $22 target price. The stock is now trading at $20.64. During the past 52-weeks, the stock has ranged from $10.60 to $22.

If you want to speculate that Mankind's stock will rally toward the target price, but not substantially above it, sell an out-of-the money call -- defined as a strike price that exceeds the stock price. Here's how it work:

Michael Schwartz, Oppenheimer's chief options strategist, recommended selling Mankind's May 22.50 calls at $3.10 and also buying the stock.

If the stock price exceeds the 22.50 strike price, and you are forced to sell the stock, the covered-call strategy produces a non-annualized return called-away return of 26%. In addition, the "effective selling price" -- defined as the options premium plus the strike price -- is higher than the $22 target price. If the stock is called away, a covered-call writer is effectively selling the stock at $25.60.

While covered-call writing is a conservative strategy that is designed to limit risk, and profit, the temptation to some aggressive traders is to "over leverage" by selling more calls than stock.

(c) Barrons, Oct 20

 

[RussianMike]

Not that conservative, by the way. If stock is now at 20.64 and call is priced at 3.10 (I'm neglecting trading costs for simplicity) You limit your profit but not neccesarily your loss, once stock goes to 17.54 (20.64-3.10) you start losing money. If you use this you have to make sure that you sell stock and get rid of call before you start losing money. btw stock closed at $20.30 on Friday

 

[alain]

Not that conservative, by the way. If stock is now at 20.64 and call is priced at 3.10 (I'm neglecting trading costs for simplicity) You limit your profit but not neccesarily your loss, once stock goes to 17.54 (20.64-3.10) you start losing money. If you use this you have to make sure that you sell stock and get rid of call before you start losing money. btw stock closed at $20.30 on Friday

But you have some cushion before you start losing money.

I didn't understand how the article come up with 26% return. Maybe I did a wrong calculation.

 

[dstefan]

Not that conservative, by the way. If stock is now at 20.64 and call is priced at 3.10 (I'm neglecting trading costs for simplicity) You limit your profit but not neccesarily your loss, once stock goes to 17.54 (20.64-3.10) you start losing money. If you use this you have to make sure that you sell stock and get rid of call before you start losing money. btw stock closed at $20.30 on Friday

``Conservative" is in the eye of the investor

Indeed, if the stock goes down in price below 17.54, you loose money.

 

[dstefan]

I didn't understand how the article come up with 26% return. Maybe I did a wrong calculation.

You did not - the return is actually 24%.

Note that interest is assumed to be zero, and the return is for the investment, non-annualized.

You have $20.64 to invest. You buy one share, and also sell a call with strike 22.50 for $3.10. If the option expires in the money (i.e., if the price of the stock at maturity is greater than 22.50), the call will be exercised, and you sell the share for $22.50.

You started with $20.64 and now have $22.50 from the call having been exercised plus $3.10 from selling the call (no interest added to this).

Return:
\[\frac{22.5+3.1-20.64}{20.64} = \frac{4.96}{20.64} = 24\%\]

 

[alain]

I didn't understand how the article come up with 26% return. Maybe I did a wrong calculation.

You did not - the return is actually 24%.

Note that interest is assumed to be zero, and the return is for the investment, non-annualized.

You have $20.64 to invest. You buy one share, and also sell a call with strike 22.50 for $3.10. If the option expires in the money (i.e., if the price of the stock at maturity is greater than 22.50), the call will be exercised, and you sell the share for $22.50.

You started with $20.64 and now have $22.50 from the call having been exercised plus $3.10 from selling the call (no interest added to this).

Return:
\[\frac{22.5+3.1-20.64}{20.64} = \frac{4.96}{20.64} = 24\%\]

I thought that I started just spending $20.64 minus $3.10 that I got from the calls. So I just spent $17.54. If the calls are in the money, I have to sell at the strike price and I get $22.50 so the return should be:
\[\frac{22.5-17.54}{17.54} \approx 28\%\]

correct?

 

[dstefan]

better than what I suggested, indeed, still not 26% though

 

[RussianMike]

hmm. so both answers are correct? Unless they both get averaged and we get 26% .