Monday, 17 Nov 2008
Just what is a ‘covered call’, and how can you benefit by selling one, anyway? To answer that question, let’s determine if you’re a candidate to sell options against the long equity position you currently own. Answer each of the following questions:
1.) Do I own at least 100 shares of a stock that offers exchanged-traded equity options?
2.) Am I intermediate-term (4-8 months) bullish on the stocks I own?
3.) Do I want to keep my long stock positions, regardless of market volatility?
If you were able to answer all three questions with a ‘yes’, then you may be a good candidate to sell call options against your existing stock holdings. Here’s an example of how a long-term investor (not a trader) might construct a covered call position to generate income:
If you own 100 shares of Newmont Mining, having purchased them for $24 late last month, and you expect Newmont to be trading at $42 by June 2009, you could sell a $45 June 2009 call option for approximately $130 as I write this. Your account would immediately be credited with the $130 (less commission) and you would still own your 100 shares of Newmont. The one drawback is that you cannot sell your 100 Newmont shares until either you buy back the option you sold against the position or until the option expires worthless.
On the ‘plus’ side, look at the advantages of selling the call option against your stock:
1.) You’ve lowered your cost of acquiring 100 shares of Newmont from $2400 ($24 * 100 shares) to $2270 ($2400 - $130 in option premium).
2.) If Newmont continues to rise through the third Friday of June 2009, rising to say, $40.87 the option will expire out of the money (if Newmont stock is selling for less than the call option strike price of $45) allowing you keep all of your shares. You would also retain all of the option premium and would be able to sell Newmont at $40.87, generating gains on the 100 shares as well.
3.) If Newmont were to strongly trend, hitting $52 on or before June 2009 options expiration, your 100 shares of Newmont would likely be ‘called away’ (it is a a ‘call’ option, after all) at $45. Even though you miss out on extra profits in the stock, you’ve still done pretty well for yourself, earning $2230 in capital gains from the stock and option sales.
There is another potential drawback, but for those who are long-term bullish on gold mining stocks, it might be a minor inconvenience. If Newmont were to decline to say, $20 by June 2009, the option would expire worthless and you would still own the 100 shares of Newmont. You’d have an open loss of $400 on the shares, but the gain on the option sale would leave you only $270 in the red. You could even sell another call option against Newmont, especially if you were still bullish on the stock’s long-term prospects.
Final thoughts:
Only sell a covered call if you have strong reason to believe the shares you own are in a long-term bullish trend and the stock’s industry group fundamentals also suggest that higher prices for your shares are likely. Take some time and do your homework, and you too, may be able to reap the rewards of selling covered calls against your long stock positions.
Donald W. Pendergast Jr.
Article Source: http://EzineArticles.com/?expert=Donald_W._Pendergast_Jr.