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Making Money with Stagnant Stocks - Options Mastery Series Lesson 37

Filed Under Options Mastery Series 

Making Money with Stagnant Stocks
 
Most stock investors can become comfortable investing in stock options. The fundamentals are easy to understand and usually, once an investor has purchased stocks on margin, it becomes a fairly easy transition to stock options. However, to make the process of transitioning to options easier, it’s a good idea to start using stocks and options in combination.
 
One of the most simple and conservative ways to incorporate options into a trading strategy is to use what is called “Covered calls” (aka “Buy-write”).
 
Covered Call/ Buy-Write
 
This basic options strategy is made up of buying stock and then writing a call; “writing” means selling. This strategy is also called a buy-write because stock is owned or purchased and calls on the stock are sold on a one-to-one ratio. In other words, if you purchase or already own 500 shares of IBM, to set up a covered call position you would sell (write) 5 IBM calls (each contract is 100 shares). In exchange for selling the rights of your shares to the call buyer, you receive payment. This payment is referred to as the premium. If the premium for one share of IBM is $4.00, you would receive $400 for each contract or in the case of our example a total of five contracts is $2,000.
 
If at the end of the option period the IBM stock hasn’t gone into-the-money, you get to keep all of the premiums you collected. If IBM stock is currently worth $ 120, your 500 shares would be worth $60,000. If your covered call strategy works as you hoped, the $2,000 premium collected yields a 3.3% return based on the value of the stock. Not bad for one month seeing that this strategy can be repeated time and again with the same stock. Of course, if you were successful for 12 straight months, your return would be 39.6 %. So, if your long term hold stocks aren’t performing and you don’t want to sell them, consider writing covered calls while you’re waiting for them to appreciate.
 
But what happens if the options you sold go into-the-money? Well, first the buyer of the option must exercise their rights by requesting the stock you owe them at the strike price you sold the options for. For example, if you sold 5 options contracts of IBM with a strike price of $125, you would be required to transfer 500 shares of IBM stock at a value of $125 per share. So, if you had purchased the stocks at $110, you would make the $15 profit per share and also keep the $2,000.
 
However, if IBM continues skyward, that would be your opportunity cost of being forced to hand over your stock. By the same token, if IBM goes down in value, you suffer the loss of the stock, but the premium you collected helps to mitigate the losses. For instance, on the $2,000 premium you collected in the example, the IBM stock would have to go down $4.00 to breakeven. So, in effect a covered call strategy does provide some limited downside protection associated with the holding of the stock. Because of these fairly benign consequences, the covered call strategy (or buy-write) is considered a conservative position and is allowed by most retail brokerages.
 
When to use the Covered Call strategy
 
This strategy is called a premium collection strategy and gains are based on the non movement of the stock. Normally, stock investors think of a gain as something coming from the appreciation of the stock (if long) or devaluation of the stock-if short. Rarely does it occur that money can be made by no movement at all!
 

For information on stock options-from beginner to expert-contact the Options University at www.optionsuniversity.com

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