Seeking Alpha
Recommended for you:
Profile| Send Message|
( followers)  

While using options can be a risky strategy, it can also be very profitable. My focus today is on writing options i.e. selling options. Specifically, I want to focus on writing covered call options, which is in fact widely considered a conservative strategy. I have divided the article in two parts. The first focuses on how covered call strategy works. Experienced Investors may want to skip this part and move to the second part in which I focus on writing covered calls for Intel Corp. (NASDAQ:INTC).

Part 1: Understanding Covered Calls

Traders use covered calls in order to boost their investment income. As you may know, the buyer of a call option has the right but not the obligation to buy the underlying asset at a strike price any time before the expiration date. The option buyer pays a premium to the writer or seller of the option. The upside potential for the option buyer is unlimited, while the downside is limited.

Now let's focus on our strategy i.e. selling or writing covered calls. Firstly, covered calls basically mean that when you are writing or selling the call option, you own the underlying stock. This is important because writing naked call options i.e. selling call option without owning the underlying asset, is a very risky strategy.

Let's say I own 100 shares of a company, which I bought for $25. I decide to write a call option expiring in 30 days at a strike price of $26. The option premium is $1 per share, which I receive upfront from the buyer of the call option.

Let me first establish why I am writing this call option. I basically expect the stock price to rise in the long-term but don't expect a significant upside potential in the short-term. By writing a covered call, I am generating some return in the short-term. The ideal scenario for me therefore would be if the stock price appreciates in the 30 days but not significantly. Let's say it gets to $25.50. The buyer of the call option does not exercise the option since the current price is below the strike price. Meanwhile, I keep the option premium, which is $100. In addition, there is some capital appreciation. Of course, in real world there will be commissions on the trades but to keep it simple I am excluding any commissions on the trade for now.

The other scenario could be if the stock price falls significantly. In this case, the option won't be exercised; I keep the $100 premium. But I take a loss as the stock price falls below the initial price paid for the stock. Now, unless there is a significant drop in the stock price, I wouldn't worry because as I said before, I bought the stock expecting an appreciation in the long-term. So short-term moves, if not very significant, won't have any major impact on my strategy.

Finally if the option is exercised i.e. if the current price crosses the strike price, my profit would be $100 for the premium plus the $1 per share I make by selling the stock at strike price.

As I said before, writing covered call is a relatively conservative strategy. It helps in offsetting downside risk, and it allows generating some return in the short-term if the stock remains stable.

There are a number of factors that I consider before writing covered call options. The most important is volatility. The strategy works best with stocks that have low implied volatility.

Part II: Intel Covered Call Strategy

Earlier this month, INTC had slashed its revenue outlook for the third quarter and also withdrawn its outlook for the full year. The company plans to provide updated guidance for the full year next month, when it releases its third-quarter results.

The downward revision of third-quarter revenue can be attributed to weakening PC demand. The increasing demand for smartphones and tablets has hurt PC sales and this does not augur well for chipmakers such as INTC and Advanced Micro Devices Inc. (NYSE:AMD). The launch of Microsoft Corp.'s (NASDAQ:MSFT) Windows 8 will provide a boost to PC sales in the near-term, which is a positive for INTC.

However, the future is mobile computing.

INTC has been slow in making the shift to mobile computing, and this has hurt the company in the recent past. However, the company is catching up with the likes of ARM Holdings Plc (NASDAQ:ARMH) and Qualcomm (NASDAQ:QCOM). And this makes me bullish on the stock in the long-term.

INTC is currently trading at a P/E ratio of just 9.79 and has a dividend yield of 3.89%. I think this is a great opportunity to buy and hold INTC if you are looking for long-term capital appreciation. But in the short-term, I don't see any upside potential.

If you are looking for short-term gains on INTC then writing covered calls is the best strategy. The reason I have chosen INTC is because of its attractive valuation right now, upside potential in the long-term (assuming that the option is not exercised and I hold on to the stock) and low implied volatility.

With the help of the IVolatility Covered Call Calculator, I calculated the possible returns for call options expiring in October, November and December. The IVolatility Covered Call Calculator helps in calculating annualized returns of covered call option strategy using factors such as days to expiration, option premium, strike price, commissions and dividend.

It is likely that you may already be holding INTC shares, however, for calculating the returns I am assuming that INTC shares are bought at Friday, September 21, 2012, closing price of $23.12. Suppose 100 shares of INTC are bought at $23.12 and one call option contract is sold, here are the possible results under various scenarios. Commission for buying 100 shares and writing one call option contract is $10 each.

Scenario 1-Writing Call Option Expiring at close of trading on October 19, 2012; Strike Price-$24; Premium-$0.24

If the stock is called at expiration the annualized return using this strategy is 53.15%. If the stock is unchanged at expiration the annualized return is 2.3%. The break-even point is $23.08.

Scenario 2-Writing Call Option Expiring at close of trading on November 16, 2012; Strike Price-$24; Option Premium-$0.39

Including Dividend-If the stock is called at expiration the annualized return under this strategy is 36.97%. If the stock is unchanged at expiration the annualized return is 11.8%. The break-even point is $22.70.

Excluding Dividend-If the stock is called at expiration the annualized return is 30.54%. If the stock is unchanged at expiration the annualized return is 5.4%. The break-even point is $22.93.

Scenario 3-Writing Call Option Expiring at close of trading on November 16, 2012; Strike Price-$25; Option Premium-$0.17

Including Dividend-If the stock is called at expiration the annualized return under this strategy is 58.67%. If the stock is unchanged at expiration the annualized return is 5.5%. The break-even point is $22.92.

Excluding Dividend-If the stock is called at expiration the annualized return is 52.31%. If the stock is unchanged at expiration the annualized return is -0.8%. The break-point is $23.15.

Scenario 4-Writing Call Option Expiring at close of trading on December 21, 2012; Strike Price-$24; Option Premium-$0.57

Including Dividend-If the stock is called at expiration the annualized return under this strategy is 25.93%. If the stock is unchanged at expiration the annualized return is 10.5%. The break-even point is $22.52.

Excluding Dividend-If the stock is called at expiration the annualized return under this strategy is 21.98%. If the stock is unchanged at expiration the annualized return is 6.5%. The break-even point is $22.75.

Scenario 5-Writing Call Option Expiring at close of trading on December 21, 2012; Strike Price-$25; Option Premium-$0.30

Including Dividend-If the stock is called at expiration the annualized return under this strategy is 38.31%. If the stock is unchanged at expiration the annualized return is 5.6%. The break-even point is $22.79.

Excluding Dividend-If the stock is called at expiration the annualized return under this strategy is 34.40%. If the stock is unchanged at expiration the annualized return is 1.7%. The break-even point is $23.02.

Based on my strategy, which is to hold INTC long-term and generate short-term returns using covered calls, I would initially go for the first scenario i.e. writing October 19 Strike 24 call option.

The reason for opting for the first scenario is that based on the current trend INTC is not likely to hit $24 in the next one month (remember I want to hold INTC shares long-term). The annualized return using this strategy is lowest but I am only looking to generate some short-term returns while holding on to INTC long-term. Also, if the option is not exercised at expiration, I can write another call option expiring in November and continue generating short-term returns without taking significant risk. In addition, there is no risk of losing out on dividend payments using this strategy.

Source: Covered Call Options Strategy For Intel