Friday, 12 February 2016

PHILOSOPHY BEHIND WRITING COVERED CALLS

COVERED CALL WRITING is a popular strategy among individual investors. It has also attracted the attention of mutual fund and ETF managers and there are a number of funds that use covered call writing as part of their investment strategy. I would offer a short list, but I do not want to recommend that anyone use such funds. 
If you have the time and willingness to trade your own money (as millions of stock investors do), then writing covered calls is something to consider.
It is not a good investment choice for everyone. 
When writing covered calls, stock selection is the single most important factor in determining your success or failure. Yes, selecting which option to write plays a big role in your performance, but if you own stocks that under-perform the markets on a regular basis, then you cannot expect to earn much (if any) money.
WHO WOULD WRITE COVERED CALLS?
Covered all writing begins with stock ownership and this article is written for such stockholders. It presents the pros and cons of adopting covered call writing (CCW) as a small or substantial portion of your investment portfolio.
CCW is also used by investors who have no current position in the individual stock, but who would buy shares with the intention of writing options and collecting the premium.
WHY WOULD ANYONE WRITE COVERED CALLS?
As with any other trading decision you must compare the advantages and disadvantages of the strategy and then decide whether the risk vs. reward profile suits your investment goals.
WHAT DO YOU HAVE TO GAIN?
·         INCOME. By selling one call option for each 100 shares of stock that you own, you collect the option premium. That cash is yours to keep, no matter what happens in the future.
·          SAFETY. It may not be a lot of cash (although sometimes it is), but any premium collected offers the stockholder limited protection against a loss when the stock price declines. For example, when you buy stock at $50 per share and sell a call option that pays a premium of $2 per share, if the stock price declines, you are $2 per share better off than the stockholder who decided not to write covered calls.
You can look at it from two equivalent perspectives: Your cost basis is reduced by $2 per share. Or your break-even price moves from $50 to $48.

·         PROBABILITY OF EARNING A PROFIT. This is often overlooked, but if you own stock at $48 per share, you earn a profit any time the stock is above $48 when expiration arrives. If you own stock at $50 per share, you earn a profit any time the stock is above $50 per share. Therefore the stockholder with the lower cost basis earns money more often (whenever the price is above $48 but below $50).
WHAT DO YOU HAVE TO LOSE?
·         CAPITAL GAINS. When you write a covered call, your profits become limited. Your maximum selling price becomes the strike price of the option. Yes, you get to add the premium collected to that sale price, but if the stock rises sharply the covered call writer loses out on the possibility of a big profit.
·         FLEXIBILITY. As long as you are short the call option (i.e., you sold it but it has not yet expired and you have not yet purchased that same option to cover the short position) you cannot sell your stock. Doing so would leave you "naked short" the call option. Your broker will not allow that (unless you are a very experienced investor/trader). Thus, although it is not a major problem, you must cover the call option at the same time as, or prior to, selling the stock.
·         THE DIVIDEND. The call owner has the right to exercise the call option at any time before it expires.  He/she pays the strike price per share and takes your shares. If that option owner elects to "exercise for the dividend" and if that occurs prior to the ex-dividend date, then you are assigned an exercise notice and sell your shares. In that scenario, you do not own shares on ex-dividend day and you are not entitled to receive the dividend. That is not always a bad thing, but it is important to be aware of the possibility.
 TAKEAWAY: CCW is a good strategy for an investor who is bullish enough to own stock (that comes with downside risk), but who is not so bullish that he/she anticipates a huge price increase. In fact the whole idea behind CCW is a simple trade-off:
The call buyer pays a premium for the possibility of earning 100% of any price increase (before the option expires) above the strike price. 
The covered call seller (writer) accepts the premium and keeps it as income. In return he sacrifices any capital gains above the strike price. The obligation to sell stock lapses when the option expires. That's the deal. It is a like it or hate it proposition.

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