Covered Call Strategies
Covered call strategies have advantages and disadvantages. A covered call is essentially giving up a stocks potential for capital gains and exchanging it for income... As you probably can imagine, value investors and contrarian investors, or those who bet on a stock that they believe has underappreciated in value and is on the way down or moving sideways will generally be able to see some value in this. Income investors will love the extra yield.
Merrill Lynch quantitative strategist Richard Bernstein in his book Style Investing: Unique Insight Into Equity Management offers a very useful conceptual framework for understanding the role of earnings and earnings expectations in stocks price growth. The cycle starts from the low where contrarian investors thrive, to the top where the growth investors thrive. Although it is possible to sell deep in the money calls which may allow you to profit on anything from torpedo stocks that have peaked and are plummeting, to contrarians. Or even using higher strike price calls that can allow you to profit from contrarian to growth, generally you would probably want to target any strategy from Dogs to estimate revision. In other words, you want to target stocks that have already been in declined and have surpassed the 2nd half of their decline, to stocks that have began climbing and are less than half way through their moves. To understand this more, check out Richard Bernsteins book Style Investing: Unique Insight Into Equity Management .
Any type of investor could hypothetically use covered calls to his or her advantage. However the stronger move the strategy expects to make with the stock, the quicker you must cut your losses, and the higher strike price you must sell calls. Of course there's also someone that might operate more like Buffett and find companies that are so well managed and so undervalued and have such a good business model that the time frame you own the stock is forever. In this case, you may wish to own a stock through all of the cycles and continue to sell calls and just vary your strategies according to the cycles.
If you wish to execute a covered call you would buy 100 shares of the stock, for every call you sell. If you are using an option spread strategy, your call is still covered if you own another call at a different strike price and/or a different expiration date, but we will not get into this right now.
The thing about covered calls is that it has a few advantages 1) Most stocks will never produce an infinite return which allows you to sell high strike calls to eternal optimists when you think the stock may go up, but won't go up forever. Provided that the premium is more than the fees, you collect income. 2) One thing is certain, that time will continue - a) A stock has value based on it's value of executing the option and selling it immediately.. If a stock option has a strike price of $50 and the stock is priced at $55, this value (known as intrinsic value) is $5. b) A stock option has value based potential. That same option with $5 in intrinsic value is worth more if the stock is expected to make large moves (known as implied volatility). The reason is of course, if someone bought that option, they are more likely to pay more if they believe there is going to be a large move. The supply and demand would of course dictate that a stock expected to move higher would have a high implied volatility. c) A stock option has value based on it's time remaining. That same option with $5 intrinsic value with 6 month until expiration, obviously isn't going to be worth as much as an option with 1 month until expiration. An interesting thing results though. People aren't going to want to lock up cash to own a long term option if they could buy month by month. So time value decays very slowly early on in it's contract, and it accelerates the closer you get until expiration. So someone who buys a long term option will find that this time value does not decay very fast at first, while someone who buys an option that expires in 6 days would find that time value quickly evaporates. As such, in terms of time value alone, it is more expensive to buy 6 1 month options month at a time for 6 months than it is to buy a single 6 month option. The future is less certain to most people, so the way the LEAP(long term option) market works is it is given a high implied volatility 3) Protection against downside - Options can offer value in hedging downside risk. If you buy a put, you are insuring a loss from the current price all the way to 0. If you sell a call, you are protecting your loss to only what you paid for your option. Lets say for example you owned a 100 shares of a $50 stock. If you sold a $50 strike price with 1 month, you might receive $2 a share or $200 for it. You would be protected if the stock went from $50 to $48. However if the stock went to $46, you would still lose $200 rather than $400, but still a loss on paper. The deeper in the money the strike price is, generally the lower the Time and potential value (known as theta). However, the further out of money the option gets, the less probability the stock has of reaching it, so the theta is lower there as well. Generally at the money options will have the most theta. If you purely will be an income collector, you want stocks that stay neutral, and continue to collect the theta through covered calls. A strategy that seeks to take advantage of the cycle will sell deep in the money calls as the person expects the stock to go lower, then sell closer to in the money calls as the cycle begins to cause the stock to flatten out, and then to take advantage of appreciation sell out of the money calls just slightly, and as the stock moves stronger upwards further out of the money calls can be sold. - 23199
Merrill Lynch quantitative strategist Richard Bernstein in his book Style Investing: Unique Insight Into Equity Management offers a very useful conceptual framework for understanding the role of earnings and earnings expectations in stocks price growth. The cycle starts from the low where contrarian investors thrive, to the top where the growth investors thrive. Although it is possible to sell deep in the money calls which may allow you to profit on anything from torpedo stocks that have peaked and are plummeting, to contrarians. Or even using higher strike price calls that can allow you to profit from contrarian to growth, generally you would probably want to target any strategy from Dogs to estimate revision. In other words, you want to target stocks that have already been in declined and have surpassed the 2nd half of their decline, to stocks that have began climbing and are less than half way through their moves. To understand this more, check out Richard Bernsteins book Style Investing: Unique Insight Into Equity Management .
Any type of investor could hypothetically use covered calls to his or her advantage. However the stronger move the strategy expects to make with the stock, the quicker you must cut your losses, and the higher strike price you must sell calls. Of course there's also someone that might operate more like Buffett and find companies that are so well managed and so undervalued and have such a good business model that the time frame you own the stock is forever. In this case, you may wish to own a stock through all of the cycles and continue to sell calls and just vary your strategies according to the cycles.
If you wish to execute a covered call you would buy 100 shares of the stock, for every call you sell. If you are using an option spread strategy, your call is still covered if you own another call at a different strike price and/or a different expiration date, but we will not get into this right now.
The thing about covered calls is that it has a few advantages 1) Most stocks will never produce an infinite return which allows you to sell high strike calls to eternal optimists when you think the stock may go up, but won't go up forever. Provided that the premium is more than the fees, you collect income. 2) One thing is certain, that time will continue - a) A stock has value based on it's value of executing the option and selling it immediately.. If a stock option has a strike price of $50 and the stock is priced at $55, this value (known as intrinsic value) is $5. b) A stock option has value based potential. That same option with $5 in intrinsic value is worth more if the stock is expected to make large moves (known as implied volatility). The reason is of course, if someone bought that option, they are more likely to pay more if they believe there is going to be a large move. The supply and demand would of course dictate that a stock expected to move higher would have a high implied volatility. c) A stock option has value based on it's time remaining. That same option with $5 intrinsic value with 6 month until expiration, obviously isn't going to be worth as much as an option with 1 month until expiration. An interesting thing results though. People aren't going to want to lock up cash to own a long term option if they could buy month by month. So time value decays very slowly early on in it's contract, and it accelerates the closer you get until expiration. So someone who buys a long term option will find that this time value does not decay very fast at first, while someone who buys an option that expires in 6 days would find that time value quickly evaporates. As such, in terms of time value alone, it is more expensive to buy 6 1 month options month at a time for 6 months than it is to buy a single 6 month option. The future is less certain to most people, so the way the LEAP(long term option) market works is it is given a high implied volatility 3) Protection against downside - Options can offer value in hedging downside risk. If you buy a put, you are insuring a loss from the current price all the way to 0. If you sell a call, you are protecting your loss to only what you paid for your option. Lets say for example you owned a 100 shares of a $50 stock. If you sold a $50 strike price with 1 month, you might receive $2 a share or $200 for it. You would be protected if the stock went from $50 to $48. However if the stock went to $46, you would still lose $200 rather than $400, but still a loss on paper. The deeper in the money the strike price is, generally the lower the Time and potential value (known as theta). However, the further out of money the option gets, the less probability the stock has of reaching it, so the theta is lower there as well. Generally at the money options will have the most theta. If you purely will be an income collector, you want stocks that stay neutral, and continue to collect the theta through covered calls. A strategy that seeks to take advantage of the cycle will sell deep in the money calls as the person expects the stock to go lower, then sell closer to in the money calls as the cycle begins to cause the stock to flatten out, and then to take advantage of appreciation sell out of the money calls just slightly, and as the stock moves stronger upwards further out of the money calls can be sold. - 23199
About the Author:
Maclin Vestor teaches about a few examples of an online trading system and teaches you to find an options trading system that works for you.
posted by X - Men @ 10:13 AM
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