Covered Call Returns 5% a Month

A covered call is an option combination trade which involves buying the stock, and selling a call against that stock.

One purpose of a covered call is to earn extra income and enhance the return on the stock. The downside to a covered call is that your profit potential is limited. The good thing about a covered call is that it can be done every month, and with weekly options it can be done every week!

BP’s stock dropped 50% during May & June, because of the oil spill in the Gulf of Mexico. The story is not over yet, besides the actual damage that was caused, there is still unknown future damages which they may be liable for.

Many investors are now holding onto stock that they paid $50 a share for and it is now trading at $38.50. Naturally, these same traders didn’t sell the stock as it was tanking because that is just human nature not to set a stop loss order.

Where will the stock go from here?

Personally, I do not think the stock is going anywhere too far in the next few months. Maybe 10% up or 10% down but it will probably stay in the $35 – $40 a share range.

I will try to buy the stock and start selling call options, either the weekly or monthly options against it.

Based on Friday’s closing prices the stock was at $38.47. I can either sell the Aug 6th $39 call for $0.67 or I can sell the Aug 21st $40 call for $1.00.

Assuming we buy 100 share of the stock for $38.50 a piece and then sell the $40 August 21st call for $1.00 that gives us a total cost of $3750. (The stock cost $3850, minus the premium of $100 received from the sale of the $40 call.)

If the stock closes above $40 a share on August 21st then we will make a maximum profit of $250. If the stock is at $39 a share on August 21st then we will have made a profit of $100 from the $40 call expiring worthless and we still have the stock that we paid $38.50 a share. If the stock is still at $38.50 a share, then the option we sold will expire worthless and we will have made $100. About 2.5% return in three weeks!

The ideal scenario is for the stock to finish trading as close to the strike price at expiration. After expiration, we will then have the opportunity to sell a new call option against our stock. Sometimes the stock will shoot higher than the strike price of the option we sold, and this means that on option expiration day we will be forced to sell our shares to the owner of the call option. They refer to this as having the shares called away from you.

This article was originally published on August 1st 2010, The truth always endures!