— by George Leong, B. Comm.
There is some current topping action in the markets. In fact, I see a potential set-up for a bearish head and shoulders formation. Should markets edge higher but fail to break the previous high, we could see some selling in the near term.
Given the topping in the near term, you may want to make some extra trading capital through an options trading strategy known as “covered call writing,” a widely used option strategies used by traders. The strategy is simple to conceptualize and makes a lot of sense in this market.
I will assume you own a long position that you want to write calls on. You can also write calls on an index, but we will not discuss that in this column.
Covered call writing involves writing an equivalent number of call option contracts to match your long position. This strategy is geared to the investor who doesn’t mind holding the underlying security. Investors employing this strategy could be either bearish or neutral.
By “writing a call” the investor would sell the call option in the market. By doing so, the writer is obligated to deliver the underlying security at a predetermined price also known as the “exercise or strike price.” Each option contract represents 100 units of the underlying security.
For instance, let’s say you own 100 shares of Cisco Systems, Inc. (NASDAQ/CSCO). By writing the call, you are legally responsible to deliver 100 shares of Cisco at the strike price to the buyer of the call option if exercised. Each option contract has an associated expiry month. For instance, the January 2010 call expires on the Friday prior to the third Saturday of October or whatever month is specified. If the option is not exercised by this date, it is said to expire worthless. In this case, the expiry date is January 15, 2010.
In some cases where the writer (the seller of the option) wants to close out the option prior to the exercise date, buying the same number of calls on the same security would be enough to eliminate the original obligation.
So, why use a covered call writing strategy? There are three key reasons. The writer reduces the risk of holding the underlying security. Say Cisco drops in price, the writer would offset a portion of the loss of the long position by the premiums paid by the buyer of the call.
This premium is the income generated by the writer, which is the second major reason for a covered call strategy.
The final reason is that the writer can predetermine a price at which the underlying security would be sold; thereby guaranteeing a selling price.
Let’s take a look. An investor writing one Cisco January 2010 $24.00 call option under a covered strategy is obligated to sell to the buyer upon exercise 100 shares of the stock at $24.00 per share (strike price). For assuming the risk of exercise, the writer of this particular Cisco call option receives a premium of $85.00 per contract ($0.85 per share x 100 shares).
The “covered” in the strategy means that the writer holds 100 shares of the underlying stock. Upon exercise, these shares would be delivered to the buyer of the call option at the strike price. By being long in the stock, the upside risk of the call options is hedged.
The writer guarantees a selling price of $24.00 for the Cisco shares. However, the writer will miss out on any gains above $24.00.
For the covered call writer, the maximum risk is the cost of the underlying security (what you paid for Cisco) less the premium received. This is the case when the stock moves to zero.
The maximum reward is the difference between what you paid for the stock and the strike price plus the premiums received.
Take a look at covered calls, as this strategy may work well for you.
Due to the higher risk inherent in options, I recommend that you speak with an investment professional before deciding to employ any strategy involving options.