Covered Calls Are a Careful Step Into Options Market : Investments: These promises to sell stock work best when the market is ambiguously trading in a narrow range.
Individual investors who like trading stocks can squeeze some extra profit from an uncertain market by taking a conservative step into the options market.
They can sell covered calls--promises to sell the stocks they already own.
It’s a strategy that Naples, Fla., money manager Richard Schmidt calls “awesome--the derivative we know and love.”
On the upside, such a strategy will pay you to wait with a stock that is trading in a narrow range. The downside, is that if the share price goes up past the “strike price” set in the call, the stock can be sold out from under you. In the right circumstances, even that’s not so bad.
Here’s how it worked recently for Schmidt, who publishes the Risk Report, an investment newsletter. He bought Motorola for $48 a share, and watched the share price drop to $44 and then back up to $48. More than once.
Reasoning that the stock was going nowhere fast, he sold a covered call on the shares he owned, promising to sell his Motorola stock for $50 a share in October. The calls were $4.50 per share; on 100 shares he would have pocketed $450, less the $30 he paid his deep discount broker to place the order.
Motorola share prices slid. When the stock hit $46, the same calls he sold were selling for $2.50 per share: He bought them back, for a net gain of $1.40 per share (after broker’s commissions coming and going.) And still had his Motorola.
What could have happened? Schmidt could have held the stock and not repurchased the call.
Had Motorola passed $50 before the option expired, his stock would have been sold. He still would have $4.50 a share for the call, plus the $2 per share that was the difference between his purchase price and the $50 “strike price” at which the call required he sell. If Motorola never passed $50 during the period when the call was outstanding, the option would just expire at the end of the three months.
It’s a strategy that works, but only in a narrow set of circumstances. It doesn’t work for “buy and hold” investors who like to pick blue chip companies, ignore their market activity for 20 or 30 years, and then cash in the certificates. It may not work for investors who are trading outside of a retirement fund: Capital-gains taxes can eat away much of the profits. And it probably doesn’t work for investors who use full-service brokers, says Schmidt.
It takes the discounts offered by a cut-rate broker to make the strategy add up.
When is the situation optimum for selling covered calls? When the market is ambiguously trading in a narrow range.
Should the market move out of its doldrums and hit an upward trajectory, investors would do better to hold on to their winners than to sell them for the price of a call and a couple of dollars.
Should the market become a full-fledged bear, there wouldn’t be enough money out there buying calls to make it worthwhile.
If your interest is piqued, keep these tips in mind as you tread into new waters:
* Use your retirement account. If you sell a covered call and the stock you love ends up bought out from under you, you can always just buy it again. All this trading has no tax impact in a tax-deferred retirement account like a Keogh or a SEP IRA.
* Sell calls only on big-name stocks that see lots of activity. They always have some people buying and others selling. Sell calls on a stock that’s too obscure, says Schmidt, and “everyone could end up on the same side. You could be the market on a given day.” Schmidt’s picks for selling covered calls include Caterpillar Inc., Chrysler Corp., Home Depot and Williams Companies.
* Learn the trading range of your stocks. Sell the calls when you are near the top of the range; they’ll fetch a heftier price. Then, buy them back at bargain prices when the stock goes to the low end of its range.
* Set a “strike price” that is comfortably above the top of that range.
* Be prepared to watch your stocks more carefully than you otherwise might. If you have a call outstanding against a stock in your portfolio, you really need to monitor the stock’s price.
* Crunch the numbers. Make sure you have enough shares, low enough brokerage fees, and a high enough offering price before you sell calls. Otherwise you could just be buying a lot of activity for nothing.
* Learn more. Options contracts are listed in the major financial newspapers, and a quick study of the tables will help you understand what’s really out there.
The Options Industry Council, a trade group that includes the major options exchanges, distributes a free video and pamphlet explaining options strategies. It’s called “The Options Tool” and you can get it free by dialing 1-800-952-8665.
