Taking Cover with Covered Calls

Selling options can generate extra income on your portfolio

The worst of the bear market is behind us, we hope, but that doesn't mean a 1990s-style bull market is ahead. A slower economy, rising energy costs, and badly beaten tech and telecom sectors are likely to keep gains in check. Such an environment is ideal for "covered call writing"--generating extra income by selling call options on stocks you own.

Sure, options are derivatives, and many equate derivatives with risk. But writing covered calls is a relatively conservative strategy. You can make money even if the market doesn't rise. And covered calls provide some protection against falling stock prices, though generally not enough to offset a steep plunge. Still, it's "safer than holding the stock outright," says Todd Salamone, research director at Schaeffer's Investment Research, a Cincinnati publisher that specializes in options.

Covered calls are not only for portfolio protection. Some investors and mutual funds buy stocks specifically because the prices on their options make it attractive to write covered calls.

Whether you are writing calls on long-term holdings or those you just bought, the mechanism is the same. When you write a covered call, you agree to sell your stock for a specific price by the option's expiration date. Each option has several expiration dates to choose among. Say you purchased 100 shares of IBM at the May 4 closing price of $115.86, and then wrote a June 120 call. If the stock price is above $120 when the option expires on June 18--options expire on the third Friday of the month--your shares will be "called" away from you, forcing you to sell at the below-market price of $120. (Typically, options are exercised only on the expiration date.)

To compensate you for the chance the stock will be called away, you receive a payment for the option, called a premium. The size of that premium is determined by trading in the option when you place your order. On May 4, the premium for the June 120 call was $4.30--which actually means $430.00, since each call option covers 100 shares. With that premium in hand, you could withstand a fall of $4.30 per share--to $111.56 from a purchase price of $115.86--before feeling pain. If the stock skids further, say to $105, you will take a loss. But without the call's premium, your loss would have been greater. "Covered writing is not an insurance strategy," warns James Bittman, senior instructor at the Options Institute, the educational arm of the Chicago Board Options Exchange and the author of Options for the Stock Investor (McGraw-Hill, $32.95). "It provides limited income, which provides limited downside protection." If the stock tumbles and you want to sell, you can cancel the option by buying it back--and liquidate your stock position.

You don't have to be a heavy hitter to play this game. True, it's more economical to execute big trades, because brokerage commissions are typically about $25 for the first contract and then decline sharply. But because it takes only 100 shares to write a call, an outlay of $3,000 would suffice for a stock trading at $30. Brokerages often require call writers to have an account worth at least $10,000 and a net worth of $25,000 or more, Bittman says.

Before calling your broker, you would do well to consult with a tax expert, because the rules are complex. For instance, when you collect a premium for writing a call, you don't pay taxes on it immediately. Instead, how the option ultimately plays out determines whether you pay short or long-term capital-gains taxes on profits.

Don't write calls on stock you don't want to sell. For example, if you bought IBM at $20 and your stock is called away at $110, you will owe capital-gains taxes not only on the premium you received but on a hefty $90 of appreciation. Instead of forking over highly appreciated shares, you are free to buy new stock to satisfy the call. But that's risky because the cost of the new shares could wipe out your profit on the covered call.

MANY CHOICES. The key to successful option writing is selecting the optimal strike price--or the amount for which you would be willing to sell the stock--and expiration date. With most stocks, you get several alternatives. Take IBM (IBM ). On May 4, when the stock closed at $115.86, commonly traded strike prices on IBM calls ranged, in $5 increments, from $110 to $125, according to ivolatility.com, a Web site that lists data on call options. For each strike price, an IBM call writer could choose between six expiration dates.

The strike price you select depends on how you view IBM's prospects. For example, if you think the stock could hit $130 in the near term, it makes little sense to sell a June call with a strike price of $120. Sure, you will pocket a $4.30 premium. But if the stock reaches $130, your shares will be called away at $120.

Conversely, if you think IBM might be under some near-term pressure, you can get some protection by writing a call at a strike price below where the stock currently trades, such as $110. The fat premium on IBM's June 110 call--$9.90--would protect someone who bought at $115.86 until the stock fell to $105.96.

So what are you really earning by writing calls? First, calculate the "static" rate of return (table). This is the amount you will earn on the call if the stock is at its purchase price when the call expires. Assuming a purchase price of $115.86, IBM's June 120 call, for instance, has a static return of 3.9%, so you are protected for as much as a 3.9% decline in the stock. (Returns are actually lower once commission costs are factored in.)

You may be more tempted by the static return on the June 115 contract. But you're getting a higher premium because you face another risk--that the stock will rally and you will be forced to give up the stock at a below-market price.

With this in mind, many pros opt for a strike price slightly above a stock's current price. They are still able to capture a fairly high premium, but they also leave some room for the stock to rise before hitting the strike price. This guarantees them a piece of the action in a rally.

TIGHT CAP. How much? Calculate the "if called" rate of return. Generally, the more a call protects on the downside, the stingier its payoff in a rising market. In the case of IBM's June 115 call, the premium is big enough to offset a 6.1% sell-off on a purchase price of $115.86. But if IBM rises, the call writer's gains are capped at 5.4%. In contrast, the June 120 call covers a fall of up to 3.9%, while positioning you to share in a gain of up to 7.6%. That may not sound like much, but if you earn even 3.9% in six weeks, that equates to an annualized return of more than 30%.

As a strategy, covered call writing is most profitable when your shares are called. Why? Say you buy IBM at $115.86 and write a June 120 call. If the stock rises above $120, you can kiss your stock goodbye. But you will receive $4.14 of appreciation, plus a $4.30 premium. In contrast, if the stock rises to $119, the call will expire worthless and you will get the premium plus an unrealized gain of $3.14. "If the stock gets called away, you've made the most you could on the trade," says Bill Yates, president of DYR Associates, a Vienna (Va.) risk management consulting firm.

Once you have settled on a strike price, decide on an expiration date. Pros often write the call that throws off the most premium per unit of time. Compare IBM's May 120 and June 120 calls. On May 4, the May came with a $1.63 premium, while the June netted $4.30. As of May 4, the May contract was a better deal. Why? It was set to expire in 14 days, giving almost $0.12 per day vs. about $0.10 for each of the 42 days remaining on the June call.

Covered-call strategies force investors to master a new set of rules and calculations beyond what it takes to invest in stocks. But with many bullish stock market strategists arguing that equity returns will be more modest in the coming decade than they were in past two, option writing may be one of the few ways investors can really enhance their returns.

By Anne Tergesen

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