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What You Need To Know About Covered Call Trading

|Includes:Yamana Gold Inc. (AUY)

by Karim Rahemtulla, Investment Director, Smart Profits Report

As promised last week, this is the start of a series on options strategies I’ve planned in order to show you a world of possibilities that the mainstream “press” quite simply doesn’t want you to pay attention to.

At the risk of sounding like a conspiracy theorist, I firmly believe that most investors are intentionally kept in the dark about anything that breaks away from the “buy stocks and mutual funds” mantra that makes Wall Street money.

Most mutual fund managers can’t see much further beyond Investing 101, and too many people in general are skeptical of options altogether. The problem is that they have no idea what they’re missing.

The options market was created for professionals, institutional money managers, and those who report to their wealthy, sophisticated constituents instead of the general public. But that doesn’t mean that the average Joe and Jane can’t use it too. They just need to get a few pieces of inside information first.

When George Soros took down the Bank of England to the tune of billions of pounds, he did it by using the leverage that options provided him. Basically, he saw a trend and figured out how to exploit it legally and with a surprisingly small amount of risk.

Sure, if it went against him, he would have lost out big time, but not nearly as much as someone who played the game the usual way. You see, the key to trading options is knowing how to use them to maximize the efficiency of your money. And the first and easiest strategy for doing that is the covered call trade…

Get “Free” Money

In order to execute a covered call trade you need to use both a stock and an option, hence the term “covered.” It means that your trade is covered by the underlying shares that you own.

There is no risk to the broker when you execute it since there is protection of equity by the shares you already own even if it goes against you. And that’s the reason why covered calls can be used by anyone in any type of account, including your retirement account.

When you enter into a conventional covered call trade, you’re essentially pledging to sell your shares at a certain price - known as the strike price - on a certain date, commonly referred to as expiration.

For pledging your shares, a buyer pays you an amount of money called a premium. And it doesn’t matter what the final outcome is; you still get to keep that premium regardless of who ends up with the shares in the end.

Since it’s yours to keep, spend or reinvest, you reduce the basis of your stock. Remember: Anytime you reduce your basis or capital risk, you also reduce your risk.

The One, Two, Threes Of A Covered Call

A typical covered call trade would go something like this:

Step 1: You buy 1,000 shares of Yamana Gold (NYSE: AUY) for $8.40 per share, totaling $8,400, and since you believe that the stock can go to $10 by year’s end, you look at an options chain (a listing of options available) to find out what the market is buying and selling the Yamana $10 options for.

(Note: This market is open to anyone who wishes to buy or sell options)

Step 2: The option is trading for $0.90 on the bid and $0.95 on the offer, so you sell 10 contracts of the Yamana January $10 call options, receiving proceeds of $900.

Now a few things to keep in mind before we go on…

  • Just as with stock, you buy at the offer and sell at the bid.
  • Options are always priced in increments of $0.01, $0.05 and $0.10 depending on volume traded and selling price. The Yamana options are priced in $0.05 increments and the price reflected is per share x 100 shares.
  • Options trade as contracts, and each contract is equivalent to 100 shares of stock. So while the Yamana options are priced at $0.90 by $0.95, the minimum dollar amount that you need to be aware of is for 1 contract or $90 by $95. And it also means for the purpose of covered call trading, that you need to own at least 100 shares of Yamana to execute the trade.
  • The strike price of $10 means that the buyer or seller of the option has the right to either buy or sell Yamana at $10 depending on the strategy used. If the option is sold - as in the case of a covered call trade - the seller of the option is obligated to deliver shares of Yamana to the buyer of the option if the shares close at $10 or higher.

The buyer of the option then has the option of taking delivery of the shares or selling the option back into the market.

As Close To A Win-Win Conclusion As You Can Possibly Get

Step 3: With your cost now reduced by 90 cents per share to $7.50 ($8.40 - $0.90), you wait for one of three possible outcomes.

Yamana closes at $10 or higher at expiration in January, in which case your shares will automatically be sold to the buyer of the option at $10 per share.

(In order for the buyer in this case to have made any money, Yamana would have to close at $10.90 ($10 strike price + cost of $0.90 per option) or higher. Anything less, and it wasn’t worth it.)

If it closes at $10 or higher you make 33% on your money ($10 strike minus $7.50 cost = $2.50 profit. $2.50 profit divided by $7.50 cost equals 33%). Or…

Yamana stays at $8.40 come expiration. In that case, as the seller, you still make money because you took in $0.90 per option you sold. Therefore, your return on the trade would be 12% ($8.40 minus $0.90 = $7.50. $0.90 divided by $7.50 = 12%) and you would still retain ownership of the shares since they didn’t close above $10. Or…

Yamana closes below $8.40, in which case you still make money, since your cost was $7.50. The only way you lose money if Yamana closes below $7.50, your adjusted cost and your breakeven point.

Covered Calls: As Simple As That

Basically, just as long as Yamana closes below $10, you retain ownership of those shares. And from there, you can either sell your stock at a time you see fit or keep it to sell even more call options against your position, reducing your cost even more in the process.

And as the owner of the shares, you’re entitled to any dividends paid out to shareholders during your stint as owner.

So let’s summarize:

  • A covered call trade requires you to own the shares that you then sell options against.
  • The money received from selling the options is yours to keep immediately.
  • If the shares close above your strike price, they will be taken away (called away) from your account automatically and the money will be deposited in your account.
  • Covered calls can be done in any type of account, including retirement accounts.
  • Covered call trading can generate additional income while reducing your risk.

Next week, we’ll explore a variation on covered call trading that can reduce your risk substantially while still providing double-digit returns.


Disclosure: No positions

Stocks: AUY