The Covered Call An Investment Strategy to Keep You in the Money and Out of Trouble The Covered Call An Investment Strategy to Keep You in the Money and Out of Trouble Maureen Magner

Presentation Overview Historical look at the options market Historical look at the options market Review of terms Review of terms Covered call example Covered call example Rules of the game Rules of the game Commissions and the market maker Commissions and the market maker The tax advantage The tax advantage

Investment Objective To make money for the investor or yourself over a broad range of stock prices.

Evolution of Risk Management Job sold short The covered call in 15 th century Venice Herring and the 16 th Century Futures Market Options innovations at the Amsterdam Bourse in the 17 th century

April 26, 1973 The first government regulated exchange in the world’s history to deal with stock options opened – CBOE Chicago Board Options Exchange

Five Option Exchanges CBOE Chicago Board of Options Exchange CBOE Chicago Board of Options Exchange AMEX American Stock Exchange AMEX American Stock Exchange PHLX Philadelphia Stock Exchange PHLX Philadelphia Stock Exchange Pacific Exchange Pacific Exchange ISE International Securities Exchange ISE International Securities Exchange

The Options Clearing Corporation (OCC) The common clearing entity for all SEC-regulated options transactions Selects companies to be listed on the option exchanges Selects companies to be listed on the option exchanges Guarantees that the terms of an options contract will be honored Guarantees that the terms of an options contract will be honored

Stock Options Two Basic Flavors ◊ Call : The right to buy 100 shares of the underlying stock at the strike price before the expiration date. ◊ Put : The right to sell 100 shares of the underlying stock at the strike price before the expiration date.

LEAPS Long-term Equity Anticipation Securities They are just like regular options except for longer duration. Expiries can be out as far as 3 years and 3 months.

What is a Covered Call ? A call is considered covered when its seller owns the underlying stock. For example: If a person sold a stock option on Coca-Cola when he/she owned 100 shares of Coca-Cola, he would have sold a “covered Coca-Cola call”.

Who Should Consider Covered Calls? An investor who is neutral to moderately bullish on a specific stock. An investor who is neutral to moderately bullish on a specific stock. An investor who is willing to limit his upside potential in exchange for some downside protection. An investor who is willing to limit his upside potential in exchange for some downside protection.

How Day Trading Works Andy Borowitz, The Trillionaire Next Door, 2000, HarperCollins Buy Stock Visit Sex Sites Sell Stock Become Trillionaire Log-on

Buy 300 Shares of Stock at $20 share P R O F I T L O S S Stock price Payoff 20 $6000

Sell 3 Naked Calls $7 / Share, E=$15, Cost=$2100, t=6 mo. Stock price E Profit 22 $2100 P R O F I T L O S S

Covered Call Example Buy 300 shares$20/share +$6000 Sell 3 calls $ 7/share E=$15-$2100 +$3900 +$3900 Stock priceE $4500 $ L O S S P R O F I T $15 x 300 = $4500

Annualized Return Scenarios On a Six Month Investment Stock falls $6 Stock Stock rises $6 Stock falls $6 Stock Stock rises $6 (-30%) unchanged (+30%) (-30%) unchanged (+30%) Stock -60% 0% +60% alone -$6/share - +$6/share Naked P= (P-(S-E))= (P-(S-E))= call +$7/share +$2/share -$4/share Covered +15.4% +30.7% +30.7% call +$1/share +$2/share +$2/share

How do we limit the loss in the event the stock starts to crash? Place a stop-loss order to sell the stock when it has declined to a predetermined price and buy back the call at a much reduced price. or Buy back the covered call option at the much reduced price and immediately write it again at a lower strike price.

Selecting Stocks & Options Buy a stock that you believe is going to do well and you would feel good about owning. Buy a stock that you believe is going to do well and you would feel good about owning. Always compare potential annual returns on a call before choosing a stock for covered call writing. Always compare potential annual returns on a call before choosing a stock for covered call writing. The safest covered call is the one with the lowest strike price. The safest covered call is the one with the lowest strike price. Look at the stock’s volatility- read the company news about potential merger. Look at the stock’s volatility- read the company news about potential merger. Usually lower priced stocks have higher premiums (percentage-wise). Usually lower priced stocks have higher premiums (percentage-wise). Higher options volumes generally means less of your money to the market maker. Look on Higher options volumes generally means less of your money to the market maker. Look on

Commissions Example Charles Schwab on-line account Open a $5000 account with Schwab Open a $5000 account with Schwab $29.95 for the first options contract $29.95 for the first options contract $2.00 for each additional options contract $2.00 for each additional options contract $29.95 for up to 1000 shares of stock $29.95 for up to 1000 shares of stock If fewer than 10 trades per month 3 cents per share over 1000 shares 3 cents per share over 1000 shares Total commissions on covered call example: $ (2 x 2) + $29.95 = $63.90

Taxation of Stock Options The Un-simple Story Capital losses can be offset dollar-for-dollar against not only capital gains but also $3000 of ordinary income. Capital losses can be offset dollar-for-dollar against not only capital gains but also $3000 of ordinary income. Premium money received is not considered taxable until the covered call ends. Premium money received is not considered taxable until the covered call ends. When the covered call is not exercised, the premium is a short-term capital gain. When the covered call is not exercised, the premium is a short-term capital gain. If the call is exercised, the premium plus the strike price become the sale price of the stock. If the call is exercised, the premium plus the strike price become the sale price of the stock. If profit is made on an in-the-money covered call, the IRS says that it is short term capital gain – even if the stock is called. If profit is made on an in-the-money covered call, the IRS says that it is short term capital gain – even if the stock is called.

Advantages of the Covered Call Less risk than just buying stock Less risk than just buying stock Take in the premium of the call Take in the premium of the call Earn dividends (if any) on the stock Earn dividends (if any) on the stock If the stock is not called away, sell additional calls to bring in additional premiums. If the stock is not called away, sell additional calls to bring in additional premiums. Disadvantages Forfeit the upside potential of a stock price increase Forfeit the upside potential of a stock price increase Commissions and the market makers spread Commissions and the market makers spread

Bibliography Ansbacher, Max. The New Options Market. Fourth Edition. New York: John Wiley and Sons, Inc., Borowitz, Andy. The Trillionaire Next Door. New York: HarperCollins Publishers, Gross, Leroy. The Conservative Investor’s Guide to Trading Options. New York: John Wiley & Sons, Inc., Friedentag, Harvey C., Stocks for Options Trading: Low-Risk, Low-Stress Strategies for Selling Stock Options – Profitably. Boca Raton: CRC Press LLC, Murphy, John J. Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications. Paramus, NJ: New York Institute of Finance, Steinherr, Alfred. Derivatives: The Wild Beast of Finance. New York: John Wiley & Sons, Inc., Stringham, Edward. The Extralegal Development of Financial Trading in Seventeenth-Century Amsterdam.