Many traders start their Option trading with one of two very simple positions.  The two positions are the Covered Call and the Married Put. 

The Covered Call Strategy involves writing (selling) a call against stock that is already owned.  If you write a Call without owning the stock it is called a “naked” call.  The Covered Call Strategy can be a procedure that makes any stock a “dividend” stock.  This strategy is perfect for a buy and hold investor.  This strategy makes a few assumptions:

     1)  The investor likes the stock and wants to own it.

     2)  The stock is not too volatile, meaning the price of the stock does not vary much, or stays within a channel.

     3)  The investor is willing to accept the full risk of a downward move in the stock.

There are two types of positions that can be employed when using the Covered Call Strategy.  The first, which is the one I will discuss here in detail, is selling near the money options that expire in the next month or two, and the second is selling extended duration options that are deep in the money.  If people want examples of strategy #2 please leave a comment.  In strategy #1, we sell options that expire in a month or two in order to capture the time value of the option.  The time value of an option accelerates to $0 as the option approaches expiration. 

For this discussion, lets look at Archer Daniels Midland (ADM).  Here is a chart of the last three months (I am using the last three months, because before that three months everything fell dramatically, and I am using current examples)

 

3 month Chart of ADM March 13, 2009

3 month Chart of ADM March 13, 2009

As you can see ADM has basically stayed between $24 and $30, so lets say we buy 100 shares today at $27.76 (full cost would be $2,776.00 + trading costs).  Here is a list of the near the money Call options expiring in April.

April Call Options - ADM

We could write (sell) the ADMDF $30 strike option for $0.95 (I would try a limit order at $1.00).  This $0.95 represents time value as there is NO intrinsic value in this option because it is Out of  the Money (OTM).  The ADMDE option priced at $3.50 has $2.76 of intrinsic value ($27.76 – $25.00) and $0.74 of time value ($3.50 – $2.76).  At this point we want ADM to continue to appreciate, slowly.  Remember, the investor wants to own this stock (would own it without writing calls).  Here is the risk/return graph for this position.

ADM Covered Call

At this point, there are two possible outcomes:

     1)  ADM stays below $30, then the option expires worthless and we can sell the next option.  The return for the month is $0.45 ($0.95 less trading costs, I will assume $0.50, and this includes the trading costs on the stock, which is only paid in the first month) option premium received for a return of 1.6% for the month ($0.70 if we do not include the trading costs of the stock, for a 2.52% return for the month).  This as a simple Annual Percent Return (APR) of 19.45% (or 30.26%) not including compounding.

     2)  ADM is above $30, then the option will be exercised.  We sell ADM for $30 (this is the strike price of the option that we sold).  The return for the month is $2.44 ($30 Strike price – $27.76 Purchase price + $0.95 Option premium received – $0.75 trading costs) or 8.79% for the month (105.48% APR).  If this happens we can decide to repurchase ADM or look for another opportunity.

These outcomes do not include any dividends received for owning the stock through an ex-dividend date, if this were the case the dividend would need to be included as a gain in the calculation.

The worst case for this strategy is for the stock to decline drastically.  If this happens, the investor will need to decide whether to sell options that could produce a realized loss, sell the stock for a loss or hold the stock and hope for a positive return.

Next the Married Put…

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