Wednesday, November 25, 2009

Covered Call Options: Part 2 – Definitions of Option Terms

Options are mysterious and arcane - the black magic of investing – primarily because they have their own language. The language of stocks and bonds is more than most people want to try to master. Options seem to be a completely different language – not a mere dialect of investing but something completely different. As such, they are intimidating.

I’m not an expert investor – let alone an expert options trader. But I’ve dabbled in the covered call enough to understand the basics; and, enough to want to learn more.

So, here is a short vocabulary in options – enough, I hope, to let you make an informed decision about the usefulness of covered call options to your personal investing.


Option (or options contract, or contract)
A binding contract in which one person promises to sell and deliver to another person 100 shares of the common stock of a specific company for a specific selling price. The contract is valid for a specific period of time and after the designated end date the contract is void. The buyer of the contract is not required to exercise his rights under the contract but the seller of the contract is required to deliver as agreed if the buyer exercises the contract.

Expiration Date
The expiration date is the specific date on which the options contract will become void. The buyer of the contract must exercise his rights under the contract before the expiration date because on the expiration date he loses those rights. All options contracts have an expiration date.

Underlying Stock
The underlying stock is the 100 shares of the specific company for which promises to buy or sell are made in the options contract. All options contracts have underlying stock.

Striking Price (or strike price)
The striking price of the options contract is the price at which the underlying stock will change ownership if the options contract is exercised. All options contracts have a striking price.

Call (or call option, or call contract, or call options contract)
A call option is an options contract in which the seller of the option promises to sell the underlying stock to the buyer of the option.

Put (or put option, or put contract, or put options contract)
A put option is an options contract in which the seller of the option promises to buy the underlying stock from the buyer of the option.

Covered Call (or covered call option, or covered call contract)
A covered call is an options contract in which the seller of the call option actually owns at least 100 shares of the underlying stock.

Naked Call (or uncovered call)
A naked call is an options contract in which the seller of the call does not own at least 100 shares of the underlying stock. If the options contract is exercised, the seller of the call must buy shares of the underlying stock in order to deliver them to the buyer of the call option – and yes, people actually do this.


These are the definitions you will need to understand the covered call. Using these definitions, the next post will review how to analyze a potential covered call to determine if you can expect to make money on the trade.

Links to Other Topics in the Special Report: Covered Call Options

Special Report: Covered Call Options

Links to Other Topics in the Special Report: Covered Call Options

Covered Call Options: Part 1 - What Are Covered Call Options?
Covered Call Options: Part 2 - Definitions of Option Terms
Covered Call Options: Part 3 - How to Analyze a Covered Call Option

Friday, November 20, 2009

Covered Call Options: Part 1 – What Are Covered Call Options?

Options are mysterious and arcane. They’re the black magic of investing. Few understand them and fewer make money with them. But there is one straight-forward class of options and the way to use them to make money is clear – writing covered calls.

Writing a covered call means selling to someone else an option to buy your stock. A single covered call options contract gives the buyer the right to purchase 100 shares of your stock in the specified company (the underlying stock).

Since not all stocks have options contracts, the first requirement to sell (or write) a covered call option is that you must own at least 100 shares of a stock for which options are traded. So check with your broker to see if options are traded for your stock.

When you have at least 100 shares of a stock that has options trading, your next task is to determine your broker’s commission structure for writing covered call options contracts. My broker charges a flat rate per transaction plus a surcharge for each 100 share contract in the trade. This has the effect of reducing the cost per contract on multiple contract transactions. I have only used one broker for selling covered calls so I don’t know if this commission structure is standard. In any case, you need to determine exactly what your broker will charge.

The commission structure is very important because the prices of options contracts vary all over the place and you want to be sure that when you sell your covered call you make enough money on the sale to pay the commission and a profit large enough to make it worth the trouble

The next post will review some basic options definitions.

Links to Other Topics in the Special Report: Covered Call Options

Friday, November 13, 2009

Flexible Spending Accounts: Part 2 – Calculating a Safe Contribution

If you aren’t participating in your Flexible Spending Account, you’re literally giving money to the Internal Revenue Service unnecessarily. Still, if you go overboard on your contributions you can lose money

Start calculating a “safe” flexible spending account contribution by listing everything you spent out of pocket on health care last year. Capture the description and out of pocket expenditure for each line item. Classify each item as covered or not covered and repeatable or not repeatable.

Example Expense List:

Annual physical exam; $25; covered; repeatable
Blood work for physical exam; $25; covered repeatable
Semi-annual dental exam; $30; covered; repeatable
Emergency room; $150; covered; not repeatable
Aspirin; $12; covered; repeatable
Multivitamins; $10; not covered; repeatable
Band-Aids; $4, covered, repeatable
Nail Clippers; $3; not covered; not repeatable
Wrist Brace; $7; covered; not repeatable
Shampoo; $4; not covered; repeatable

Covered expenses include co-pays for medical, dental, and vision office visits, lab work and tests, and any hospitalization or emergency medical expenses. Out of pocket expenses for prescription and over-the-counter medications are covered as are prescription and over-the-counter medical devices and supplies.

In general, if you incur the expense to heal, cure, or control pain then it’s probably covered. If it’s a “wellness” expense - like vitamins, food supplements, or exercise equipment - it’s probably not covered unless your doctor wrote a prescription ordering you to incur the expense.

Total the annual amount twice – once with all covered expenses and once with only those covered expenses that are repeatable.

Example (using the Expenses List):

Total of all covered items = (25+30+150+12+4+7) = $228
Total of covered & repeatable items = (25+30+12+4) = $71

Odds are good that your list will be much longer and the totals much higher than the example– but let’s continue to use the Example List.

Next, you need to know your approximate income tax rate. You can calculate an estimate of your income tax rate from last year’s Form 1040. Look up your actual tax paid and your adjusted gross income from your Form 1040.

Example Form 1040 Information:

Tax Paid = $10,000
Adjusted Gross Income = $40,000

Then divide the Tax Paid by the Adjusted Gross Income ($10,000/$40,000 = 0.25) then multiply by 100 to convert the result to a percentage (0.25 * 100 = 25%)

Example Income Tax Rate = 25%

Example “Safe” Contribution:

If you now divide the Total of covered & repeatable items ($71) by your Income Tax Rate subtracted from one (1 – 0.25 = 0.75); so $71 divided by 0.75 = $95. The result ($95) is the amount greater than the covered repeatable amount that you can contribute with nearly complete safety.

It is likely that there will also be covered non-repeatable expenses in the coming year and taking a conservative guess at them will allow you to increase the safe contribution. You may even plan non-repeatable expenses; for example, the purchase of glasses or perhaps laser eye surgery. The cost of planned expenses can be directly added to the safe contribution figure.

Once you have a year or two of experience using your flexible spending account you can simply adjust your contribution up or down based on experience.

There’s really no excuse for not getting started.

Link to Other Topics in the Special Report: Cutting Expenses

Friday, November 6, 2009

Flexible Spending Accounts: Part 1 – Saving Money with Flexible Spending

If your employer offers a flexible spending account, and you aren’t using it, you’re literally giving money to the Internal Revenue Service unnecessarily.

Many employers offer flexible spending accounts in their benefits package. These accounts are structured by federal law to allow payment of most medical-related bills using “before tax” money.

Unfortunately, the law creating flexible spending accounts also requires money that is left in the account at the end of the benefit year to be forfeited by the employee. This feature scares off many would-be flexible spending account participants. They’re afraid of losing money.

There’s really no excuse for the law to require the forfeiture of excess money. Any reasonable person would allow the excess to roll over into the next benefit year.

Nevertheless, even if you don’t spend all the money in your flexible spending account you can still save money overall depending on your income tax rate.

For example, if your income tax rate is 30% and you contribute $1,000 to a flexible spending account; the $1,000 contribution in subtracted from your gross wages before tax is applied. Since your taxable income is $1,000 less, your income tax will be $300 less (30% of $1,000).

So, by contributing $1,000 to your flexible spending account you save $300 on your income tax return. If you end the benefit year having used only $800 leaving $200 forfeited in the account – you’ve still saved $100 net. The tax reduction gives you a fair amount of flexibility that increases as your tax rate increases.

If you contribute $1,000 and:

1. Your income tax rate is 35% then you have a net savings from your flexible spending account as long as the forfeited amount is less than $350.

2. Your income tax rate is 25% then you have a net savings from your flexible spending account as long as the forfeited amount is less than $250.

3. Your income tax rate is 15% then you have a net savings from your flexible spending account as long as the forfeited amount is less than $150.

4. Your income tax rate is 0% then you have no net savings under any circumstances.

Still, if you contribute $2,000 to a flexible spending account but have only $800 in qualified medical expenses then you have a net loss of $600 ($1,200 forfeited less $600 tax savings assuming a 30% tax rate); a very undesirable outcome.

Flexible spending accounts are an easy way to save money on your income taxes – even if you forfeit a smaller amount at the end of the benefit year.

The topic of the next post will be calculating a “safe” annual contribution to your flexible spending account.

Link to Other Topics in the Special Report: Cutting Expenses