The "Stagnant" Scenario
When we apply the covered call strategy to the stagnant
stock scenario, we take a negative return scenario and turn
it into a positive scenario. Remember, when we sell an
option, we receive a premium for doing so.
When the stock does not move during the option's life, the
extrinsic value of the option goes to zero. The amount of
money paid for the option goes to the seller. We'll take a
look at how this sets up.
Let's go back to our previous example with the stock
trading at exactly $9.50. We sell the front month,
at-the-money call, which would be the 10 strike call. We
sell the front month 10 strike calls at $.50. As time goes
by, there is less chance for the option to become
"in-the-money". As this happens, the extrinsic value
lessens and finally, after Friday expiration, the option is
worthless.
The stock finishes at $10.00 and you have received no
capital appreciation but you have received the full $.50 of
extrinsic value from the option sale. If the studies are
correct and selling the premium works 80% of the time, then
you will collect approximately $4.00 per contract sold over
the course of the year.
As the examples demonstrate, writing covered calls against
a stagnant stock can provide you with an acceptable return
instead of frustration, wasted time and capital.
The "Down" Scenario
In the final scenario, where your stock purchase is headed
down into negative territory, the covered call strategy can
help minimize your losses. Although picking losers and
incurring losses is inescapable, it can be minimized and
controlled. Let's take a look at how the buy-write can help
us do that.
For example, let's say you bought a stock for $9.50 and at
the end of the month the stock had traded down to $8.50,
you would have a $1.00 loss on our investment.
However, if you had sold the 10 strike calls for $.50, you
would only have a $.50 loss. You would have a $1.00 capital
loss in the stock, but a $.50 option gain from selling the
option, which would expire worthless.
If you were going to buy the stock anyway and incur a
possible loss, it is better to take a $.50 loss than a
$1.00 loss. In this down scenario, the option premium
received helped to offset the capital loss.
If the stock is down more than the amount you received for
selling the call, then the option premium serves as an
offset to the loss of the stock.
However, you can still make money in the "down scenario"
using the covered strategy if the stock is only down a
small amount. There is a scenario in the buy-write strategy
where you can profit from owning a stock that is lower than
where you bought it.
Going back to the previous example, you bought a stock for
$9.50 and you sold the front month 10 strike calls for
$.50. At expiration, the stock finishes down $.20 at $9.30
You would have incurred a $.20 loss on your stock.
However, with the stock at $9.30, the 10 strike call that
you sold for $.50 is now worthless. So, you have a $.20
loss on the stock and a $.50 gain from the option premium
sold. This leaves you with a gain of $.30 on a stock that
is down $.20 since the time you purchased it.
To recap: in our third scenario, the "down scenario," your
loss will be offset by the option premium you received so
your loss will not be as severe. You still may incur a
loss, but it will be minimized, and minimizing losses is a
key to successful investing.
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