Are your stocks stagnating? You're not alone. These days, many stocks are just rocking back and forth in a narrow trading range. That makes it a good time to generate some extra dollars by selling "covered calls"--a fairly safe options play.
A covered call is an option you sell on stock you already own. It gives the buyer the right to purchase your shares at a fixed "strike" price for a limited amount of time--commonly, three months. For this right, the buyer pays you a premium, providing you with an instant return on a stock that may not be budging. The premium can soften the blow if the price of the stock drops.
"If you can pick up a 1% to 3% return every few months, it's a significant boost to your annual return," says Richard Schmidt, president of Stellar Management, a money manager in Naples, Fla. "It also keeps you from losing as much in a down market. The only negative is that it could limit upside gain." That's why it's not a good strategy for a bull market. And in a bear market, you might want to buy put options, which deliver a profit if the stock price drops below that specified in the contract.
But in this so-called sideways market, covered calls are the strategy du jour. Take retired businessman Glenn Caudill of Naples. He bought 6,500 shares of Motorola at $35. Now that it's trading around $50, he wants to take some profit. Instead of outright selling, he had his broker "write" covered calls at a strike price of $50 for $4 a share. His 65 contracts, each covering 100 shares worth $26,000, cost him $157.11 in commissions at a discount broker. The minimum commission at discount broker Charles Schwab is $39. A full-service broker would charge around $751 for the same deal. The call is then traded on an options exchange.
Investors who think Motorola could go above $54 will buy the call. But if the stock is still $50 when the call expires in October, the buyer won't exercise it. Then Caudill can keep the stock and the $4 per share premium--for an 8% return in only three months.
"BUILT-IN PROFIT." If the stock drops to $45, the buyer also won't exercise the option because he can purchase Motorola on the open market for less. When the call expires, Caudill would have a $5 per share paper loss, but an offsetting $4 gain from the premium. Thus the call would protect him against a small price drop.
If the stock rises above $50, say to $54, the buyer will exercise the option because at $50, the call is cheaper than the stock's price on the market. Caudill must surrender his stock for $50, but the $4 premium gives him the same profit as if he had sold it outright at $54. However, that's the most he can make. If Motorola goes to $60, he will lose out on the extra $6 per share in appreciation. But Caudill doesn't mind because he bought the stock so cheaply in the first place. "I wouldn't do this if I didn't have a built-in profit," he says.
BE PREPARED. Most covered calls are sold slightly above the current stock price. "That allows you to participate in some upside appreciation over and above the option premium," says Michael Schwartz, chief options strategist at Oppenheimer & Co. in New York. Strike prices usually come in $5 increments, so you would pick the one just above your stock price--say, $50 for a stock selling at $48.
Because a covered call limits the appreciation you can realize, write one only if you like a stock but don't think it will rise much. Conversely, if you think the stock will tank, sell it. The premium isn't much help if the price plummets. Also, only write calls on issues of companies you don't mind selling, because if your stock rises above the strike price, the buyer will probably want it. "You have to be mentally prepared for giving away the appreciation," says Bernard Schaeffer, editor of Option Adviser in Cincinnati. If you change your mind in midcall, you can buy back the option before it's exercised. And as the call expires, you can roll it over at varying strike prices.
After a year of writing covered calls, Caudill has become a fan. "The only reason I didn't use it before was nervousness about dealing in options," he says. Educational materials from the Chicago Board Options Exchange (312 786-5600) and the Options Institute (312 786-7760) helped quell his fears. So did the success that came from using the right financial strategy at the right time.
A SHORT COURSE IN COVERED CALLS
Writing covered calls is the most basic form of options trading. It means you sell to another party the right to buy stock you already own. Here's how it works:
The 1,000 shares of XYZ stock you bought for $56 each have been stagnating. You hope to generate extra income by writing a call to sell the stock at $60. The option price is $3 per share, or $3,000. The commission for 10, 100-share contracts is around $71 at a discount broker.
IF THE STOCK PRICE DOESN'T CHANGE The call buyer doesn't exercise the option at the end of three months. The call expires, you keep the stock, and collect $3,000, a 5% return.
IF THE STOCK PRICE RISES XYZ climbs to $65. The buyer exercises the call and buys the stock for $60. You make the $3 per share premium plus the $60 strike price. Your profit is $7,000, including $4,000 appreciation in the stock price. But you lose out on the two-point appreciation above $63.
IF THE STOCK PRICE DROPS If the stock falls to $50, the buyer won't exercise the call because the market price is cheaper than the strike price. You pocket the premium of $3000, which cuts your loss from $6,000 to $3,000.