How to Make Your Capital Work for You

“Calling the Trend” Column, by George Leong, B.Comm.

Since mid-January, markets have edged lower, with the DOW closing lower in seven of 11 sessions. There is above-average upside pressure and markets in fact are now more vulnerable to the downside. The DOW came within 14 points of testing 10,000 on January 29, while the S&P 500 has broken below the key 1,080 support level in each of the last three sessions.

In a market that is hesitating or showing a downward bias, you could look at a widely employed options strategy called covered call writing or buy-write.

For those of you who are new to options, covered calls means you hold an underlying position in the stock represented by the call option and is much less risky compared to naked call writing, in which you do not have an underlying position in the stock. I will remind you again to be aware of this distinction, since it will save you lots of stress and potential unnecessary losses in the long run.

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Let’s take a look at Amazon.com (NASDAQ/AMZN) and assume that you own 100 shares at a cost base of $100.00 per share. In this case, you are obviously bullish on Amazon.com, but are just not sure when the stock will trend higher from its current level or are concerned that the stock could correct.

There are several strategies at your disposal. You can sit on the position and wait for the stock to appreciate. The problem is that this is an inefficient use of capital in my view.

So why not make your capital work for you? It’s much easier than you think and represents a win-win situation. The process involves writing covered calls on your holding of 100 shares of Amazon.com. For every board lot (100 shares) of Amazon.com, for example, one call option is written.

Covered call writing is straightforward, low-risk, and a generator of premium income, and as well as guaranteeing a selling price for the stock. Don’t write a covered call if you do not wish to lose the stock due to a possible exercise from those holding the calls.

Let’s say you are near-term neutral or bearish on Amazon.com and believe the stock may have limited upside potential prior to April 2010. What’s the next step? Given this, you could generate some premium income by writing calls on your 100 shares of Amazon.com. By writing the calls, you in turn are obligated legally to deliver your 100 shares of Amazon.com at the predetermined strike price if exercised and only if assigned to you.

Here are the mechanics. You own 100 shares of Amazon.com and decide to write one out-of-the-money Amazon.com April 2010 $130 Call option contract (strike price is greater than market price) at $400.00 per contract. This is the risk premium you get for assuming the risk and is yours to keep whether the call options are exercised or not.

The strike price selected in call writing should be what you should feel comfortable selling the stock at if it were to be exercised. If the strike price is set too low, it would have a higher probability of being exercised and you might lose your shares, perhaps at a lower price than you would want. Conversely, setting a lower strike price translates into higher premiums for you. The decision ultimately depends on your view of the market.

Should Amazon.com reach the strike of $130.00 by the April 16, 2010, expiry, you would need to deliver your shares at $130.00, a 30% move from $100. That wouldn’t be that bad, plus you keep the $4.00 per share in call premium, so your gain is 34%, excluding commissions. Should Amazon.com not reach $130.00 by expiry, you keep the premium and can then roll over to another month.

Please be warned that options are more complex than stocks, so you may want to do your own research or ask an options specialist before executing a trade.