Are You Covered?

Last week I hosted a live chat to discuss “My Game Plan for the Year Ahead – Earn $1,200 a Month.”  The response was overwhelming – hundreds of you tuned in for the hour-long webinar, and many of you came equipped with some excellent questions. While I was able to get to quite a few of those questions “on the air,” I was not able to answer all of them. In today's Daily Profit, I will address some of your most pressing options questions about how I use covered calls.

If you missed the recent live event, don't worry. You can click here to watch the recorded webinar in its entirety.

Let’s get to it.

This week I am introducing a covered call strategy within my Options Advantage service. (I discuss this strategy in my latest webinar.) The strategy should serve as a valuable addition to the service beyond the credit spread and Apple portfolios that I currently maintain.

I believe all self-directed investors need to take a serious look at covered calls. This is especially true for those who feel options are a highly risky trading vehicle.

A covered call is a conservative options strategy whereby an investor holds a long position in an asset and sells call options on that same asset to generate increased income. Unlike buying options outright, this strategy allows you to take a conservative stance so you can sleep well at night.

All you need to initiate the strategy is 100 shares of stock and a highly liquid options market. By highly liquid, I mean heavily traded options that that have narrow bid-ask spreads.

If you own at least 100 shares of stock, then you have the ability to “sell a call” against your stock (assuming it has options, which most do). Remember, 100 shares of stock equals one option contract.

One of the stocks I will use for covered calls is Facebook (NASDAQ: FB). Let’s say that you’ve collected 200 Facebook shares since its IPO last year. Furthermore, you believe in the long-term prospects of the company and have no intention of selling the stock any time soon … it’s a long-term investment.

With Facebook trading at approximately $31.50, the 200 shares are worth $6,300. Again, you like the stock’s long-term prospects but feel in the shorter term that it will likely trade relatively flat to lower, perhaps within a few dollars of its current price of $31.50.

If you sell two March (expires on March 15, 2013) call options on FB at the $36 strike (this means you are selling the right to buy your shares for $36 at any point up to March 15), you could collect $71 per contract, or $142 for your 200 shares. Do this eight times per year and you could bring in $1,136. Not a bad way to tack on an additional 18% to your FB stock annually.

By comparison, if you went out to the $38 strike you could bring in $40 per contract, or $80 total. Eight times a year totals $640, adding 10.2% annually to your holding.

Obviously, the further you move the strike price out away from the current stock price, the higher your probability of success (defined as your shares not being “called away”). However, the more conservative your approach, the less option premium you bring in.

Returning to our Facebook example, one of three scenarios will play out:

1) FB shares trade flat (below the strike price) – the option will expire worthless and you keep the premium collected when you sold the calls. In this case, by using the covered call strategy you have successfully outperformed the stock.

2) FB shares fall – the option expires worthless, you keep the premium, and again you outperform the stock.

3) FB shares rise above your strike price – the option is exercised (i.e., your stock is called away) and your upside is capped at your strike price plus the option premium collected. For example, if you collected $40 per contract at the 38 strike, the covered call strategy will underperform the stock at any price above $38.80. (Note: you are selling two FB contracts because you own 200 shares of the underlying stock.)

Remember, covered calls make money when stocks are slightly higher, flat or down. You only get the underlying stock "called" away if it rises significantly.

Given how this conservative strategy works, why would any investor choose to shy away from such a proven income strategy that has outperformed the market and dividend-paying stocks over the long term? This is why I decided to introduce this strategy to my Options Advantage subscribers.

You can learn more about how I safely use options for both income and to steadily grow my investment account by clicking here.

Kindest,

Andy Crowder

Editor and Chief Options Strategist