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Covered Calls – Increasing Income

When you write covered calls, did you know that you can produce greater profits by writing six two-month covered calls per year, than you will realize writing one 12-month covered call per year? It's true - time decay for further-out options is quite small, so writing options more than few months away is equal to lost time. Based solely on option premium profits, focusing on short-term ATM or OTM contracts produces annualized double-digit returns.

An example of the covered call and how to identify profit, loss and breakeven points: You purchased 100 shares of stock two months ago and paid $54 per share. Today those shares are worth $58 and you decide to sell a covered call with a strike of 60 and expiration in two months. You receive a premium of 3 ($300).

In this example, you have several crucial price points. Your basis in stock was $54, but because you received 3 for selling the call, you net basis is reduced to $51 per share. This is your breakeven point and if the stock price moves below this level, you will have a loss. With a strike of 60, your potential profits are called as well. If the underlying stock moves above 60 and the call is exercised, your profits are limited to:

Capital gain on stock:

Exercise price, 100 shares $6,000

Less: Purchase price - 5,400

Capital gain $600

Profit on the covered call 300

Maximum profit if exercised $900

If the call is not exercised, you keep the $300 as profit. And when the call expires or when you close it, you are then free to create another covered call with a later expiration date. And as long as you own shares, you also continue earning dividends - which is one reason to limit covered call writing to value companies that also pay exceptionally high dividends.

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