by Robert Hauver
As we approach 2017, in this different market environment, we’ve received many requests recently for a detailed explanation of how to sell covered calls, so here goes:
Our Options & Investing Glossary has this brief definition: “An option strategy in which a call option is sold against an equivalent amount of long stock. Example: writing 2 XYZ May 60 calls while owning 200 shares or more of XYZ stock”.
Why are they known as covered calls? Because the call seller owns a corresponding amount of the underlying shares before selling any call options.
If you don’t own the underlying shares, you’d be selling naked calls, which is one of the most dangerous moves in the investing/trading world. The old adage, “You’ll lose more than your dignity when you walk down Wall St. naked”, refers to the treacherous scenario of selling naked calls, in which your losses can be unlimited. As long as you own the corresponding amount of underlying shares 1st, you can “cover” your sold calls position.
Let’s dig deeper into the basics:
1. Many stocks have options available, with different monthly cycles, and some highly traded, large volume stocks also have weekly options. In general, the present month and the next month should always have options available. There are also usually other option months in the future, depending on which option cycle a stock is on.
The list of option months and expirations is called an option chain.
2. American options expire after the end of the 3rd Friday’s trading day, with their assignments taking place that weekend. (You’ll usually be able to see the final outcome of your option position by Monday, except on holiday weekends.)
3. One option contract corresponds to 100 shares of the underlying stock. An option’s strike price is the price at which an option seller is obligated to sell the underlying shares, if they are assigned. Conversely, an option buyer pays a premium to buy the shares at a specific strike price.
4. Assigned: When selling covered calls, if the underlying stock’s share price has risen beyond the value of the strike price of the option sold by the seller, his shares will usually be sold, (assigned), by his broker at the sold call’s strike price, usually at or near the expiration date.
Sometimes, your shares may be assigned just before an ex-dividend date, if the buyer wants to capture the dividend $. We’ll discuss a strategy for this scenario later in this article.
1. First and foremost, if you want to sell covered calls, you must own or buy at least 100 shares of the underlying stock. It’s also best to buy in 100-share quantities of the stock, so you have 100 shares covering each option contract that you sell.
2. Select an option month: In the example below for Cummings, CMI, we chose the February 2017 list of options from the pull-down menu on the left. The Bid = the $ amount per option that call buyers are currently bidding for this $140.00 Feb. 2017 option. The Ask = the $ amount per option that call sellers are currently trying to sell this option for. (The Mid is just an average of the Bid & Ask).
3. Choose a strike price: We then chose the $140.00 call strike from the list of strike prices for CMI.
Why? Since CMI was trading at $138.06, we wanted to sell at a strike price near the money, (near CMI’s price), but above CMI’s price, so we have the potential for a price gain that’s larger than the dividends we’ll qualify for before the option expiration date.
4. Enter your sell order carefully: We then chose “Sell to Open” from the Action pull-down list on the right. We chose 1 contract for Quantity, “Limit” for order type, $4.70 for our limit price, and “Day” for our timing.
Note: If you want to make sure that your call sale goes through, you can sell at the Bid price. However, since some options have a much wider Bid/Ask price spread than this $4.70/$4.90 spread, you could try to sell for a higher-than-bid price.
Keep an eye on the Bid Size and the Ask Size – these refer to how many bidders and sellers there are for your option. If there are a lot more bidders, you may be able to sell for more than the current bid price.
In this example, we sold 1 CMI Feb. 2017 call option with a strike price of $140.00, which obligates us to sell 100 shares of CMI at $140.00/share, if our shares are assigned, (i.e., sold to a call buyer of that same option, who has exercised his option to buy 100 shares of CMI).
This $140 option expires after the market close on 2/17/2017. Call buyers are bidding $4.70 per option, which equals $470.00, since each option contract equals 100 shares of stock – (100 x $4.70=$470.00).
The next table details the income/profit for each of the 3 main scenarios you’d encounter for this trade. Note: Option profits are usually considered short term capital gains:
A. Static – If CMI doesn’t rise to or above $140.00 at or near the expiration date, your call options will expire worthless, leaving you with $573.00 income from the $1.03 dividend and the $4.70 option premium you received. You’ll also keep the underlying shares, since they didn’t get assigned.
B. Assigned before the ex-dividend date – If CMI rises to or above $140.00 near the ex-dividend date, your shares may get assigned, and you won’t receive the dividend. Always look at the potential price gain, (the difference between the option strike price and the underlying shares’ price), to see if you’ll be amply compensated for any loss of the dividend during the term of the trade.
In the CMI trade, the $140 strike price is $1.94 above CMI’s $138.06 price/share, vs. the $1.03 quarterly dividend you’d qualify for in February 2017.
C. Assigned after the ex-dividend date – If your shares get assigned after the ex-dividend date, you’d collect all 3 income/profit streams – the dividend, the option premium, and the assigned price gain. In this example, that’s quite unlikely, since CMI’s ex-dividend date may be on 2/17/17.
Our free Covered Calls Table gives you more details for this trade, and 25 other income-producing option trades.
Dividends: With its 2.97% dividend yield, CMI barely made it into the Industrials section of our High Dividend Stocks By Sectors Tables. They have a very impressive dividend growth rate of over 40%, and should go ex-dividend on 2/17/17, if they follow last year’s schedule.
Performance: CMI has had a very strong year in 2016, rising over 61% year-to-date. It has also outperformed the market over the past quarter.
Valuations: CMI looks a bit cheaper than broad industry averages on a P/E, Forward P/E, and a Price/Sales basis. However, it does command a higher Price/Book valuation.
Financials: CMI has stronger ROA, ROE, ROI, and Operating Margin figures than industry averages, and an average Debt/Equity load.
Disclaimer: This article was written for informational purposes only, and is not intended as personal investment advice. Please practice due diligence before investing in any investment vehicle mentioned in this article.
Disclosure: Author owned no shares of CMI at the time of this writing.
All tables furnished by DoubleDividendStocks.com, unless otherwise noted. Copyright 2016 DeMar Marketing. All Rights Reserved.