Friday, December 4, 2009

Covered Call Options: Part 3 – How to Analyze a Covered Call Option

Writing a covered call option is the least mysterious and arcane black magic technique of options investing. It’s simple enough that I’ve done it myself and made a few bucks.

My analysis for writing (selling) a covered call goes like this:

1. Select a stock with at least 100 shares in my portfolio that has active options trading; for example Southern Copper – ticker symbol PCU.

2. Determine the minimum price I would be willing to sell PCU if my covered call is exercised.

3. Go to my on-line broker’s web site and look up the “options chain” for the stock – PCU.

4. Choose a selection of PCU call options at acceptable striking prices and several expiration dates (near term, three months out, and six months out).

5. Get the price quotes (bid price or last price paid) for each option.

6. Calculate the profitability of each option applying my broker’s option commission structure. I use an Excel spreadsheet for this analysis.

7. Choose the most profitable option in the selection.

8. Final gut check on the striking price and the price for which I’m willing to sell the option.

9. If I decide to set a price for my covered call option different from the price quotes used in my analysis then plug my price into my analysis model to check its profit.

10. Place the trade order thru my on-line broker.

After that, you wait for the call to sell. If it sells, you wait for it to expire or be exercised. If it expires, you can start the process over and sell another call. If it’s exercised then you have just sold your stock at the option striking price.

After you place the sell order for the covered call you will either sell the call earning the exact profit you calculated or you will not sell the call - you will have lost or gained nothing.

If you sell the call the only risk you take is the possibility of having to sell your stock for a price less than the market price at the time the call is exercised. If you chose a striking price that gives you an acceptable return then the worst case is you miss making a bonus profit on the sale of the stock.

Here is an analysis of a real selection of PCU call options:

My broker’s commission structure is as follows. A $9.20 commission is charged per trade or transaction. In addition, $0.75 is charged for each contract. In this example all of the potential trades analyzed are for one contract so the total commission in each case is $9.95.

The price is the price per share so 100 shares at $0.65 per share is $65.00 – this is the amount the buyer will pay me for selling the PCU AH call. $65 less the $9.95 commission yields my profit of $55.05. If the market price rises above the $40 striking price per share then the option would probably get exercised. Since my current cost basis (the average price I paid for my PCU shares) is $21.04 per share, I stand to make a profit of $18.96 per share or $1,896 for my 100 shares - less my broker’s commission on the stock sale of $5.95.

I chose these specific call options because their striking prices are above the current $36.40 market price for PCU and, since I’m not really interested in selling my PCU shares, I want to reduce the probability of being forced to sell the stock. I also want to ensure that if I’m forced to sell I get a price I’ll be happy with.

The number of contracts offered makes a difference to the profitability of covered calls because of the option commission structure. The same analysis is shown below using four contracts per transaction.
On the PCU AI call you see the difference in profitability due to the increased number of contracts. When one contract is sold the profit is $0.05 but when four contracts are sold the profit jumps to $27.80 – considerably more than four times the original profit.

You also see that a more profitable single contract is less affected by the commission structure when the number of contracts increases.

Another consideration is the expiration date. The more time allowed before the expiration date the higher the probability the stock price will rise above the striking price. Of course, if the stock goes down the option will expire. If you want to sell the underlying stock before the option expires, you will need to buy the option back at the current market price.

Writing covered call options allows you to lock in a profit with the risk of possibly missing out on some bonus profit if the underlying stock goes up above the option striking price.

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

Covered Call Options: Part 2 - Definitions of Option Terms


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