Since an option is a depreciating asset, meaning it has a limited life, the extrinsic value in the option will wither away daily until expiration. This “decay” is not a linear function meaning it is not equally distributed between all of the days to expiration.

This is like a boulder rolling down a hill. The further it goes down the hill, the more steam it picks up until the hill ends.

By selling the option and owning the stock, the covered call seller captures the extrinsic value in the option by holding the short call until expiration.

We have now seen how a covered call strategy is constructed and how it is supposed to work. Keep in mind that the trade can be entered into in two ways. You can either sell calls against stock you already own (Covered Call) or you can buy stock and sell calls against them at the same time (Buy Write).

Example 1

You own 1000 shares of Oracle at $9.50.

The stock has been stuck around this level for a long time now and you have grown impatient. You finally give in and sell the front month (November for example) at-the-money calls. The at-the-money calls would have a strike price of $10 if the stock was trading at $9.50.

We do this mainly because the media and industry professionals have drilled into our heads, year after year, time after time, that it’s best to buy and hold. The recent bull market phenomenon also fueled this mindset because the ‘buy and hold’ strategy worked extremely well - for a while.

Whether or the not the ‘buy and hold’ strategy is still the most efficient way of investing remains a topic for discussion. However, it is still the strategy that most investors are comfortable with and tend to follow.

The first strategy we will discuss is a hybrid of the buy and hold strategy, one that provides for better and more consistent returns a large majority of the time when compared to naked stock ownership alone.

When we buy a stock, there are three possible outcomes. As we discussed previously, two of these scenarios are generally negative and only one outcome is generally positive. If the stock goes up, that is good. If the stock goes down, that is bad. And if the stock stays still, that is also a bad outcome.

To briefly recap, not only do you have a loss in opportunity cost (the money invested in your stagnant stock could be making you money if somewhere else) but also, you have incurred commission costs on both the way in and way out. So, in this case, only one of the three scenarios provides a positive return.

For the sake of description, we will identify the three potential scenarios as the “up” scenario, the “down” scenario and the “stagnant” scenario. By employing the covered call or “buy-write” strategy, you can change the outcome of the scenario profile so you have two positive potential results instead of only one.

Employing the covered call or “buy-write,” we still have the “up” scenario as a positive result, but now the “stagnant” scenario will also produce a positive result since we collect a premium and the third scenario, the “down” scenario will not be as negative.

Thanks to the covered call strategy, now two of three scenarios end in a positive result and the third has a result that is less negative.

Let’s take a closer look at the covered call strategy and its construction. There are two components of the covered call strategy, the stock component and the option component.

The stock component consists of a long stock position (you own stock). The option component consists of selling one call per every one-hundred shares of stock owned.

Remember, one option contract is worth one hundred shares of stock. So for example, 1000 shares of stock equals 10 call contracts or 200 shares equals 2 call contracts.

The chart below shows more examples of the proper construction of buy-writes.

Remember, when buying an option, you can only lose what you spend. The problem is the amount of extrinsic in the at-the-money option.

In order for you to profit from buying an at-the-money option, you need the stock to make a move very quickly. Because you have so much extrinsic value, you will be battling against the option’s daily rate of decay.

So, the movement of the stock must happen quickly enough and large enough to offset the amount of money you will be losing daily as expiration draws near.

However, with a smaller delta, the stock must move much more than either the in or at-the-money options in order for the options to become profitable. Again, we need the option’s delta to outpace the option’s rate of decay.

Now, with the out-of-the-money option, there is less extrinsic value than the at-the-money option so the amount of total possible decay (cost of the option) and the rate of this decay is less than the at-the-money option.

By being further out-of-the-money, this option needs more movement from the stock. As a naked option, this out-or-the-money example is extremely speculative and should only be used naked when the investor feels there is a very good chance of a stock having a large percentage move.

Under the proper conditions, options do not have to be paired with stock or another option to be an effective trading tool. To successfully trade naked options, an investor must realize that certain options will fit certain scenarios and certain options will not.

One of the major misconceptions that investors have about options stems from the fact that most do not know how to trade them properly. When they lose money trading them, they feel that there is something wrong with the option. They do not understand that options are on a higher, more sophisticated level when compared to stocks.

Stock trading has fewer variables involved and is therefore easier. No one is saying that the individual investor isn’t smart enough to trade options. The problem is not intelligence; it’s just education and experience. Most investors have not been properly educated in the proper use of options, and even fewer have had any real experience trading them.

One of the biggest problems investors have is this: Even if you buy a call and the stock goes up, you can still lose money. Most investors tend to buy out of the money options at a cheap price. The stock trades up a little, which is the right direction, but the option still loses money and the investor wonders why.

What the investor fails to realize is that in order for the option to be profitable the options delta must out-pace its rate of decay. Implied volatility also plays a key role if the stock does trade up while implied volatility decreases, the options delta must then outperform the decrease in volatility. Remember, when volatility increases, the price of all options goes up. When volatility decreases, the price of all options goes down.

As you wait for your stock movement, the in-the-money option will decay less than either the at-the-money or out-of-the-money options because it has less extrinsic value. The amount of money you lose in time decay must then be made back by additional stock movement.

Obviously, the less you lose in decay, the less the stock has to move for you to be profitable because it has less decay loss to make up for.

This is because an in-the-money call has a high delta and a much higher percentage chance of finishing in-the-money by expiration so they follow the stock more closely.

When applying a definition to investing in the market, we want to pay particular attention to the words “maneuvering into the most advantageous position prior to actual engagement” and the words “skill in managing or planning especially by using stratagems.”

Picking a stock or group of stocks is only half the battle. Making the most from the chosen investment opportunity is the other half. This is where your strategy comes in.

The wrong strategy even when applied to the right opportunity can produce increased risk, decreased profits and even potential loss. Therefore, understanding and applying the proper strategy is critical.

The actual selection of an investment opportunity from those offered normally depends on the type and style of research the investor favors and deems necessary.

This selection process, or “investment selection protocols,” is a checklist of different types and pieces of data that are favored by the individual investor. These pieces of data can consist of charts, indicators, oscillators, fundamental analysis, news or even tips.

Each investor has his/her own investment selection protocol. As an investor, once you complete this process and choose your investment opportunity, your strategy takes over. Inherent in the selection of the stock is expectation.

The seller of a put option assumes the obligation of taking delivery of the stock or other underlying instrument from the buyer should the buyer wish to exercise his option. The put is known as a short instrument which means that the buyer profits from the stock going down.

For the seller to profit, the stock must not move below the strike price plus the amount of money received for the sale of the option. This point is known as the breakeven point and is calculated by adding the call’s strike price to the option’s premium. Obviously, the buyer hopes that the stock price exceeds the breakeven point.

For example, you buy the MSFT January 65 put for $2.00 because you think Microsoft is going to go down. This option gives you the right, but not the obligation to sell the stock at $65.00. In order to obtain this right, you had to spend $2.00. In order for you to make money, the stock would have to trade down below $63.00 by expiration.

This is because the stock has to trade down below the strike plus the cost of the option. If the stock traded down to $60.00, you would make $5.00 because you have the right to sell it at $65.00. However, because you paid $2.00 for the put, you must subtract that from your $5.00 profit for a total profit of $3.00. You have just made $3.00 on a $2.00 investment. Not a bad return.

The buyer of the put has limited risk and unlimited potential gain. His risk is limited only to the amount of money he spent in purchasing the put. His unlimited potential gain comes from the stocks unlimited downside potential.

If MSFT declines and trades down to $55.00, the seller would realize a $10.00 loss less the amount he received for the sale of the option ($2.00), for a net loss of $8.00. Meanwhile, the buyer would realize a $10.00 profit less the amount he paid for the option ($2.00), for a net gain of $8.00 per contract.

If MSFT were to trade up to $75.00, the seller would realize a $2.00 profit (the amount of money he was paid from the buyer). Meanwhile, the buyer would only lose what he paid for the option ($2.00). The seller is obligated to take delivery of the stock from the buyer at the strike price regardless of the present market price of the stock. This is why the seller receives premium for the sale.

Again, the following graphs are called parity graphs. They are intended to show you your option’s profit and loss at expiration (when they are trading at parity: i.e. when they are trading without intrinsic value). The first graph shows a put purchase and the second shows a put sale. The graphs show the amount of your expenditure (in the case of a purchase) or the amount you have received (in the case of a sale) and the dollar price of the stock where you would breakeven.

For example, if Microsoft was trading at $53.00 and the January 50 calls were trading at $3.00, then the January 50 calls are said to be trading at parity. Under the same guidelines, the January 45 call would be trading at parity if they were trading at $8.00. So, parity for the January 50 calls is $3.00 while parity for the January 45 calls is $8.00

Now if these calls were trading for more than parity, the amount (in dollars) over parity is called ‘premium over parity.’ Thus, the term ‘premium over parity’ is synonymous with extrinsic value, which was discussed above.

If the stock is trading at $53.00 and the January 50 calls are trading at $3.50 then we would say that the calls are trading at $0.50 over parity. The $0.50 represents the premium over parity that is also the amount of extrinsic value. The $3.00 is the amount of intrinsic value or parity.

Implied Volatility is a value derived from the option’s price. It indicated what the market’s perception of the volatility of the stock or underlying will be during the future life of the contract.

A stock that has a wide trading range (moved around a lot) is said to have a high volatility. A stock that has a narrow trading range (does not move around much) is said to have a low volatility.

The importance of volatility is that it has the single biggest effect of the amount of extrinsic value in an option’s price. When volatility goes up (increases), the extrinsic value of both the calls and the puts increase. This makes all the option prices more expensive. When volatility goes down (decreases), the extrinsic value of both the calls and the puts decrease. This makes all of the option prices less expensive.

As stated earlier, a call option is a contract between two parties (a buyer and a seller) whereby the buyer acquires the right, but not the obligation, to purchase a specified stock or other underlying instrument, at a predetermined price on or prior to a specified date.

The seller of a call option assumes the obligation of delivering the stock or other underlying instrument to the buyer should the buyer wish to exercise his option.

The call is known as a long instrument, which means the buyer profits from the stock going up, and the seller hopes the stock goes down or remains the same. For the buyer to profit, the stock must move above the strike price plus the amount of money spent to purchase the option.

This point is known as the breakeven point and is calculated by adding the strike price of the call to its premium. While the buyer hopes the stock price exceeds this point, the seller hopes that the stock stays below the breakeven point.

The buyer of the call has limited risk and unlimited potential gain. His risk is limited only to the amount of money he spent in purchasing the call. His unlimited potential gain comes from the stock’s upside growth potential.

The seller, on the other hand, has limited potential gain and unlimited potential loss. The seller can only gain what he was paid for the call. His unlimited risk comes from the stock price’s ability to rise during the life of the contract.

The seller is responsible for delivering the stock to the buyer at the strike price regardless of the present market price of the stock. This is why the seller receives premium for the sale. It is compensation for taking on this risk.

For example, if a seller sold the MSFT January 65 call for $2.00, he is giving the buyer the right to buy 100 shares (per contract) of MSFT from him for $65.00 per share at any time until the option expires.

If MSFT rallies and trades up to $75.00, the seller would realize a $10.00 loss less the amount he received for the sale of the option ($2.00). Meanwhile, the buyer would realize a $10.00 profit less the amount he paid for the option ($2.00).

If MSFT were to trade down to $55.00, the seller would realize a $2.00 profit (the amount of money he was paid from the buyer). Meanwhile, the buyer would only lose what he paid for the option ($2.00).

The following graphs are called parity graphs. They are intended to show you your option’s profit and loss at expiration (when they are trading at parity: i.e. when they are trading without intrinsic value). The first graph shows a call purchase and the second shows a call sale. The graphs show the amount of your expenditure (in the case of a purchase) or the amount you have received (in the case of a sale) and the dollar price of the stock where you would breakeven.

The total price of an option (premium) consists of two components. Those two components are intrinsic value and extrinsic value.

A put option gives the buyer the right but not the obligation to sell a specific security at a specific price by a specific date. It’s a way of “locking in” the sales price of a stock for a period of time.

The specific date is known as the contract’s expiration date. On or prior to the expiration date the holder of the option contract has the right to “exercise” the option.

The term exercise means the process by which the buyer of an option converts the option into a long stock position in the case of a call or a short stock position in the case of a put.

The term assign or assignment means the process by which the seller of an option is notified of the buyer’s intention to exercise.

Buyers of options exercise. Sellers of options are assigned.

The strike price or exercise price is defined as the price at which the holder has the right to buy (for a call) or sell (for a put), the underlying security. Strike prices are quoted in dollars, i.e. May 50 calls means May $50.00 strike calls.

There are several other important terms in an option contract:

A long position is defined as any position which will theoretically increase in value should the price of the underlying security increase. Vice versa, the position will theoretically decrease in value should the underlying security decrease.

MSFT is the option class. May 65 call is the option series. May is the expiration month and 65 is the strike price.

Let’s try one more. How about the Home Depot January 35 puts? Home Depot (HD) is the option class. January is the expiration month and 35 the strike price.

All stocks and options are identified by symbol. We have discussed how the stock itself has a symbol (stock symbol HD = Home Depot, while MSFT = Microsoft.)

By derivative product we mean that it is a product whose value is based upon or derived from the price of something else. Since we are talking about stocks, a stock option is based upon, among other things, the price of the underlying stock.

There are also options on other traded securities such as currencies, indexes and interest rates, but here we will limit our discussion to stock options, or options based on stocks.

A distinguishing factor of an option is that is a depreciating asset in the sense that it has a limited life, and has to be used before the date on which it expires. As time goes by, the option loses value as it moves closer to its expiration date

The problem is that most individual investors do not have the knowledge, resources, or time to spend doing their own research, stock selection, execution, and position management.

The development and expansion of the internet has solved part of this problem in that the internet now provides timely information and resources, right at the fingertips of the individual investor.

Earnings reports, income statements, balance sheets, charts, graphs, research, chat rooms, and even CEO video conferences are easy to obtain online. Now, investors have all the tools necessary to make their own decisions.

However, for many the problem still exists. Why? Because, all the tools in the world are no good to you, if you don’t know how and when to use them. The truth of the matter is that most investors are not qualified or properly trained to interpret the use of these tools, and are therefore ill equipped to use them in making their own investment decisions.

So now what should investors do? The answer is to find someone to help you help yourself. Not to make your decisions for you, but to assist you in making your investment decisions and to help educate you as to the `how` and `why. `

You need to become more involved, and the first step in the involvement process is education.

Education is the key to successful investing for the individual investor in the market of the future.

All of us who invest in the stock market know that there are three possible outcomes after we make a stock purchase.

Second, the stocks can go down and this is usually a bad outcome.

Third, the stock can go nowhere - which is also generally a bad outcome.

It is bad because not only could you have put that money to use in something with less risk that might have produced a return, but you also incurred commission costs on the way in and out which added to your loss.

So, we see that there are three things that can happen when you take on a new stock position, and two of them are bad.

Now, what if we tell you that by employing a certain strategy correctly, you can improve your chances dramatically?

Instead of having two of three scenarios possibly go wrong, you would have two of three scenarios that could go right. And, the third scenario, the bad one, wouldn’t be nearly as bad.

It can happen by using just one of the many strategies involving teaming stocks with options.

Sound interesting?

How many think the market is performing poorly?

And how many feel the markets performance is neutral?

Actually none of these answers is correct. You see, the market does not perform, you do. You perform!

Sometimes you perform well, and other times you do not perform so well. The market doesn’t perform, it moves. It moves up, it moves down and it moves sideways.

It moves along like anything else that travels in a business cycle. If the market did perform, then you would only be able to make money in an up market.

As you know, it is possible to make money in a down market, and even in a stagnant market. Thus it stands to reason that the market simply moves and you react to it. So, let’s talk about your performance. You have two ways that you can perform, directly and indirectly.

Directly, you pick your own stocks. Indirectly, someone else picks your stocks for you, whether it is your broker or a fund manager.

In the latter case, the fact that you chose someone else to pick the actual stock does not mean that the responsibility of a loss is theirs. After all, it was you who chose them.

In the end, it is you and you alone who are responsible for your performance. Consequently, it is your responsibility to become an educated investor.

Years ago, individual investors didn’t have to worry about who was managing their money. Now, things have changed as poor returns from money managers and investment firm scandals have shaken our confidence in these ‘professionals.’

To get a better look at what lies ahead, you have to go back and look at what transpired to get you to where you are now. From there, maybe a clearer path into the future will become visible.

During the Great Bull Market of the 1990’s, many investors, like you, entered the market and reaped the returns of the largest bull market in history.

Everyone, it seemed, made incredibly high rates of return. The market’s incredible, unprecedented move appeared to make geniuses of us all - but in actuality, it masked some major flaws with many industry professionals. It also created a misconception in the general public that all market professionals were experts.

Suddenly, the bubble burst and those flaws were exposed.

Not only did we find out that most of those experts possessed more luck than skill, but we also discovered that some had been cheating us out of our hard earned savings.

Many investors were discouraged with these market developments, and to make matters worse, many had lost significant amounts of money. Not to mention, the prospect of regaining these losses seemed slim to uncertain, at best.