Should you sell COVERED CALLS?

My Covered Call Rules

My rules for writing covered calls: 1) I am willing to hold the stock for the long term. 2) I am willing to risk loosing the stock, if there is blowout news or the long term market uptrend continues. 3) I am not putting myself in a position to take a loss, I am not willing to take.

Should you sell COVERED CALLS?

The issue with buying options is time is working against you. The safest money in options is probably selling covered calls on stocks you are willing to hold for the long term. This makes time work in your favor.

I typically will only do this, it the call plus the premium is such I will be left with an acceptable profit, if the call ends in the money and the stock is called away. My goal in doing this is to establish the strike price, so it is likely not to be hit by expiration.

The advantage of not having it called away, is then I can turn around and sell a call again for a future expiration. I can view from an accounting (NOT TAX ACCOUNTING) each premium collected as reducing my cost of the underlying equity. If you do this on a stock that has a potential for a rapid price increment, you may be disappointed because you will have lost out on the big gain.

HISTORICAL and ONGOING EXAMPLE

Let me work through an example: EBAY closed at 30.87 of Friday, if I owned EBAY, on Friday I could have sold a 32.50 April call for $.62. Lets assume I bought EBAY with a cost of $30.75 and was willing own EBAY irrespective of its earnings coming up next week. If EBAY rises in the next week and my call is exercised, I will make 1.75 (32.50 -30.75) and the $.62 premium. A return of 7.7% for owning EBAY for a week. Of course, I have ignored commissions in this.

And, if EBAY turns in only okay earnings, my call won't be exercised and I can view my cost of owning EBAY as $30.13. Then a week from Monday, I can start looking at the potential for selling a May or later call on EBAY. Last trade on a May 30 was $2.29 and a $32.50 was $1.03

Where's the downside? EBAY has bad earnings and guidance. The price drops. I have to decide, if I stay a long term investor in EBAY or if I buy my discounted call back and sell the stock. EBAY has great guidance and the stock soars, I get my 7.7% for my ownership.

I sold the call, EBAY closed at less than $32.50, and since I did this in an IRA where there is no tax implication, I can view the cost of my EBAY as the $30.75 purchase price minus the $.62 premium I pocketed.

Then on April 18, I sold a July 35 call for $1.00. Now I can view my cost at $30.75 - $.62 - $1.00 or $29.13.

EBAY has been weak, I could buy my July 35 call back for $.42. Raising my cost to $29.75. Then I would have some alternatives: 1) Sell the stock and end up with only about $.50 profit. 2) Keep the stock and wait for the price to go up before selling a future call. 3) Sell a call right now.

Lets explore #3:

A) Sell July 32.50 call for .95, lowering my cost to $28.80. It does increase the chance I could be called away.

B) Sell July 30 call for $1.95, lowering my cost to $26.85. Unless I expect really a weak future for the next 55 days for EBAY, this says I have decided to bail on EBAY most likely. But I want to walk away with a profit $3.15 per share before commissions. And if by chance it is below $30, I have the ability to continue selling calls.

C) Sell June 30 call for $1.20, lowering my cost to $27.60. If I see short term weakness in EBAY and/or the market this is tempting, because it gets my stock free sooner to sell another call, but it runs a high chance of being called away leaving me with a profit before commissions of $2.40 per share. This gets me my money a month sooner than choice B.

Choice C actually, in some cases may be an attractive way to sell a stock, if you are not in a hurry to sell and you would rather be paid to sell it, rather than paying to sell it.

ANOTHER EXAMPLE

Supergen has an approved cancer drug they are licensing to a Japanese company. The stock has been beaten down on speculation that an ongoing study will show it may be inferior in extending life to a competitor. The competitor and Supergen roughly split the US market. If the study turns out positive, then J&J will file to sell Supergen’s drug in Europe. Therefore investing in Supergen, I am investing in a company with cash in the bank, near cash flow neutral, a pipeline of drugs. Supergen has about $1.40 cash per share and is trading at $2.50.

Let’s work through one potential example with actual commissions.

Buy 1200 shares of SUPG @ $2.50 = -$3009.95

Sell 12 July 2.50 calls at $.45 = $ 521.01 After $9.95 +$.75 per contract

Assuming exercise @$2.50 = $2980.01 After $19.99 assignment fee

Profit = $ 491.07 or 16.3% for tying up money for 55 days.

Some Possibilities:

1) The data turns out great and the stock soars, I have lost out on anymore profit. Maybe I should take the $491.07 and buy 200 more shares with no calls sold.

2) The data is terrible and the stock goes down, I am not in the red until the stock drops below $2.07 per share. The $1.40 in cash per share seems to provide some floor.

3) The data is delayed and the stock trades below $2.50 at options exercise. I dance and sing because I can set up another options sale.

Another example:

Buy 1200 shares of SUPG @ $2.50 = -$3009.95

Sell 12 Jan 2009 2.50 at $.85 = $ 981.02 After $9.95 +$.75 per contract

Assuming exercise @$2.50 = $2980.01 After $19.99 assignment fee

Profit = $ 951.08 or 31.6% for tying up money for 237 days.

The Jan 09 5 calls at .35 is another interesting call to consider selling. This provides the potential for doubling the money on a positive outcome.

SUMMARY

Covered calls may be used as a profit machine.

Covered calls will limit your upside gain.

Covered calls will provide some limited downside protection.

The risks are limited to the share price minus the premium obtained for the call sold.

Disclosure: Long EBAY, SUPG, UNG, DUG stock and Short EBAY, SUPG, UNG, and DUG calls.

Covered Calls aren't for everyone. This is not investment advice, it is educational in nature only. You and only you are responsible for your investment decisions.

Best of fortunes in your investment decisions.

Micro

themicrokid@yahoo.com