An Easy Option Trade You Can Execute Now On Apple, Sprint And Other Stocks

Includes: AAPL, S
by: Rocco Pendola

The email I receive more than any other asks for basic options information. At least among the Seeking Alpha readers I hear from, two distinct camps exist -- those who understand and trade options and those who have just set out to wrap their heads around basic concepts.

Nobody ever learns everything there is to know about options. Very few people, if any, pick up the basics in just one sitting. Instead, you learn the basics over time after reading essentially the same information multiple times from various sources. While I often send people to excellent resources such as the Chicago Board Options Exchange (NASDAQ:CBOE) or the Options Industry Council, I think it makes sense to show readers who are new to options how to execute simple, relatively risk-free options trades.

Writing The Covered Call

I won't say writing covered calls is for everybody because it's not. If you're a really small investor it can be more trouble - and expense - than it's worth.

Using a basic example, imagine you just started out investing and purchased 100 shares of Sprint (NYSE:S). You consider your entry price of $2.17 a fantastic bargain and intend to hold the shares for the long-term. To squeeze some income out of the position, you think about writing a covered call.

When you write (or sell) one call, you give the buyer of that call, the right, but not the obligation, to purchase 100 shares of the stock underlying the option at the contract's strike price on or before the options expiration date. Your call is "covered" by the 100 shares of, in this example, S that you own. Each options contract equates to 100 shares of stock. If you did not own the stock, your broker refers to your position as a naked, or uncovered, call. You won't be able to execute this type of trade without advanced options trading approval from your broker and enough account equity (margin) to cover the trade.

The owner of 100 shares of S could write a November $3.00 call and collect roughly $0.21 of premium income. Using the multiplier of 100, that's $21. If that call closes in-the-money by $0.01 or more come options expiration (meaning S trades at $3.01), you will most likely have your shares called away. You keep the $21, but lose your 100 shares of S, which you will sell for $3.00 a share, regardless of S's market price at the time of assignment.

While you run the risk of having your shares called away prior to expiration and a slim chance of not having an in-the-money call exercised at expiration, I, for the sake of keeping it simple, will not get into those scenarios in this article. What I explain is the most likely way things could shake out - you either keep your shares or get them called away at expiration.

Because you could pay up to $10 in commission charges at many brokerages to pull off this trade, it makes little sense to execute it. Of course, you could always pick an expiration further off into the future and collect a heftier premium, but if S rises you run a greater risk of losing your shares on a $3.00 call. If you opt for a higher strike price, you collect a smaller premium.

While I understand the argument that it's all relative, I still stand by the notion that, with low-priced stocks, bang for your buck with respect to writing covered calls increases alongside the size of your position.

I own 900 shares of S with a cost basis of $2.17. At that level, I felt like it makes sense to write the November $3 calls, so I did. I get bargain-basement commissions at Interactive Brokers (IEX:IBKR) and I would not fret if my shares get called away. While I intend for the position to be long-term, I would be more than happy having had a good time with S at $2.17 and selling it for $3.00 in just over a month's time. The $190 in income on a stock I don't actually think will get called away looks attractive.

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On the other side of the ledger, if you own high-priced, high-flying stocks, I would - with a smile, over a pint - call you crazy if you choose not to write covered calls, even if you're worried about getting your shares called away.

Consider a 100 share position in Apple (NASDAQ:AAPL). If you're sitting on profits - or even if you're not - it makes absolutely no sense to not write a covered call, given the premium you stand to collect. If you're worried about losing your shares, you can still take in income worth your while by writing deep out-of-the-money calls.

For instance, the AAPL December $440 call brings in approximately $5.20 ($520) worth of income. Looking a little more near-term, you could write the AAPL November $410 call for about $7.85, the $420 for around $4.82 and the $430 for roughly $2.70. And you can repeat this process over and over again as your calls expire. Fellow Seeking Alpha contributor Paul Zimbardo masterfully executes this strategy on AAPL using weekly options. It's an incredibly easy and lucrative way to generate income in your portfolio with minimal risk, relative to other things you could be doing.

Again, when you write a covered call, worst case scenario is that you get your shares called away. With that in mind, make sure you're setting that underlying stock position up to be a profitable one in the event you have to give up the shares. The underlying stock could also tank, but that's a risk that's not really associated with writing the covered call. That could happen anyway. At least with calls written against your position, you have some income to ease the pain. And, remember, you can close out the call position - likely for a profit if the underlying stock drops even modestly - and keep the difference between what you sold the premium for and what you had to pay to buy it back.

Disclosure: I am long S.

Additional disclosure: I have nine November $3.00 calls written against a 900-share position in S.