I have mentioned in previous posts that I am teaching a few co-workers about trading and investing in the financial markets. The first few weeks was really all definitions to build a foundation that would leave them on solid footing to understand a real trade. In my opinion after you have a basic understanding of options the first strategy to play with is the covered call. Even if this was the only strategy you ever employed you would have edge of 80% of the other retail investors/traders out there.
The covered call is a natural first strategy because it is the closest thing to doing what most people understand well, and thats buying stock. With the one difference is now we are going to sell a call against that stock that limits our upside, while at the same time providing us with a reduction in cost basis and an increased probability for success. I like to call the reduction in cost basis the "Cushion" or "Downside Protection".
Lets take a look under the hood and see what is really going on with the covered call. We will use INTC as the example stock as it is freshest in my mind from my Friday lesson with my co-workers. To provide a little context, INTC was trading right at $21/share and we were looking to sell the Mar'14 call for $1.15 at the $22 strike. Additionally INTC pays a 5% dividend. Ok, so what does all this mean?
We all understand that if we buy a stock that we make money if it goes up in value and we lose money if it goes down in value. I think we can all agree on this. Lets first take a look of what the risk/reward potential looks like with being long or buying 100 shares of INTC at $21.
Risk: $2,100 price you paid for the 100 shares (21 x 100), stock could go to zero
Reward: Unlimited Upside & 5% dividend
Break Even: $19.95/share. Assuming you hold for one year and collect the full dividend for a year. ($21 - (5% x 21))
In this example, you basically have a 5% cushion from the dividend and unlimited upside potential. Now lets take a look at the covered call and how it changes the dynamics of the position. We will now buy 100 shares and sell 1 $22 strike for $1.15/share
Risk: $1,985 price you paid less the premium you collected for the call (21 x 100 - 1.15 x 100)
Reward: $215 & 5% dividend = $320 max gain if called away or 16.1%.
Break Even: $18.80/share. Again assuming you hold for one year and collect the full dividend. ($21 - (5% x 21) - (1.15 x 100))
There are two differences between the two examples that I just outlined above:
Like I said above if you do nothing else but the covered call, you are going to do better than 80% of the market place.
Please let me know if you have any questions on this strategy. Just post below in the comment section.
Good Luck Trading!
And 1 favor that we ask:
If you like the hard work we put into our blog posts and videos, PLEASE help us out by sharing them. Click the share links below and share them on FB, twitter, etc. It really helps us get more exposure and grow IN THE MONEY TRADES!
The covered call is a natural first strategy because it is the closest thing to doing what most people understand well, and thats buying stock. With the one difference is now we are going to sell a call against that stock that limits our upside, while at the same time providing us with a reduction in cost basis and an increased probability for success. I like to call the reduction in cost basis the "Cushion" or "Downside Protection".
Lets take a look under the hood and see what is really going on with the covered call. We will use INTC as the example stock as it is freshest in my mind from my Friday lesson with my co-workers. To provide a little context, INTC was trading right at $21/share and we were looking to sell the Mar'14 call for $1.15 at the $22 strike. Additionally INTC pays a 5% dividend. Ok, so what does all this mean?
We all understand that if we buy a stock that we make money if it goes up in value and we lose money if it goes down in value. I think we can all agree on this. Lets first take a look of what the risk/reward potential looks like with being long or buying 100 shares of INTC at $21.
Risk: $2,100 price you paid for the 100 shares (21 x 100), stock could go to zero
Reward: Unlimited Upside & 5% dividend
Break Even: $19.95/share. Assuming you hold for one year and collect the full dividend for a year. ($21 - (5% x 21))
In this example, you basically have a 5% cushion from the dividend and unlimited upside potential. Now lets take a look at the covered call and how it changes the dynamics of the position. We will now buy 100 shares and sell 1 $22 strike for $1.15/share
Risk: $1,985 price you paid less the premium you collected for the call (21 x 100 - 1.15 x 100)
Reward: $215 & 5% dividend = $320 max gain if called away or 16.1%.
Break Even: $18.80/share. Again assuming you hold for one year and collect the full dividend. ($21 - (5% x 21) - (1.15 x 100))
There are two differences between the two examples that I just outlined above:
- By selling a call against your shares you are capping your upside at $22/share in return for $1.15/share. So you are collecting 5.5% for obligating yourslef to sell your shares at $22 should INTC trend higher above this strike. So you have essentially locked in a max gain of 16.1%
- By selling the call you have not only doubled your cushion or downside protection from 5% to 10.5% you have also increased your probablity of success, giving you edge over the majority of other market participents.
Like I said above if you do nothing else but the covered call, you are going to do better than 80% of the market place.
Please let me know if you have any questions on this strategy. Just post below in the comment section.
Good Luck Trading!
And 1 favor that we ask:
If you like the hard work we put into our blog posts and videos, PLEASE help us out by sharing them. Click the share links below and share them on FB, twitter, etc. It really helps us get more exposure and grow IN THE MONEY TRADES!
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