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Total Return Approach to Covered Call Option Strategies

Investors who wish to beat the market using a conservative total return approach should consider learning to invest by using covered call option strategies to enhance their total return. Writing covered calls helps to improve the total return of an investor’s portfolio if they apply several important principles.

The Total Return Strategy incorporates the return from stock ownership and the decay of the time premium of a covered call into a strategy that beats the market while lowering risk. This framework provides investors with a comprehensive way to assess the alternative returns and risks.

Total Return Strategy

Investors seek to achieve a total return on their investments that is commensurate with the level of risk they are willing to accept. Out-of-the-money and in-the-money covered calls offer different strategies for investors as they seek to achieve their investment goals. In addition to the potential return, you should also consider the downside protection that selling call options provide. In-the-money writes offer more down side protection, though they can also make money if the stock prices rises slightly. Since the premium on an out-of-the-money write is smaller, the total position is more susceptible to a loss if the stock declines more than expected. On the other hand, you can enjoy profit on the stock price rise up to the strike price as well as the income from the decay of the time premium.

The total return approach considers the potential return of the stock and the potential return of the covered call write. The decision on what option to write depends on the market trends, the strength of the underlying stock and risk tolerance of the investor. When viewed from the total return perspective, you are able to make better decisions regarding what is the right stock to use and the type of covered call option to write.

Before writing a covered call, you should understand the potential return so you can make a more informed investment decision. Before entering the covered call position, there are three basic elements of a covered call write that should be calculated. The three are the down side protection, the return if exercised, and the return if unchanged. The best way to describe these factors is to use an example. The table below shows the assumptions for an out-of-the-money call option (TIE AF) and an in-the-money call option (TIE AE) for Titanium Metals Corporation. TIE AF has a strike price of 30, greater than the current share price of 26.04. TIE AE has a strike price of 25. Both options expire on the third Friday of January 2008. I have assumed $0.10 dividends per share for this example, which is not true for TIE. I just want to be sure everyone realizes that dividends are part of the total return analysis.

Option

TIE AF

 

Option

TIE AE

Shares

300

 

Shares

300

Purchase price of shares

25

 

Purchase price of shares

25

Current share price

26.04

 

Share price

26.04

Dividend per share per quarter

 $      0.10

 

Dividend per share per quarter

 $      0.10

Stock trade commission

 $      10.50

 

Stock trade commission

 $     10.50

Option Premium Received per option

 $       0.85

 

Option Premium Received per option

 $      2.80

Option buy back price

 $       0.10

 

Option buy back price

 $      1.20

Strike price

 $      30.00

 

Strike price

 $     25.00

Expiration date (days away)

           56

 

Expiration date

            56

Option trade commission

 $      10.50

 

Option trade commission

 $     10.50

Net Investment

For this example, we also need to know the net investment required. We are also assuming this is a cash account, so we are not using margin. Margin can increase the returns, if performed properly. The table below shows the net cash investment required for each option. Note that the higher premium received for the in-the-money option provides a lower overall investment.

Net investment required - cash account: TIE AF

 

Net investment required - cash account: TIE AE

Stock cost

 $  7,500.00

 

Stock cost

 $7,500.00

plus stock purchase commissions

 $      10.50

 

plus stock purchase commissions

 $     10.50

less option premium received

 $     255.00

 

less option premium received

 $   840.00

Plus option sales commissions

 $      10.50

 

Plus option sales commissions

 $     10.50

Net cash investment

 $  7,265.65

 

Net cash investment

 $6,680.65

Downside Protection

One of the reasons to write a covered call is to provide some down side protection. After all, you are receiving cash by committing to sell your shares at the strike price. Calculating the downside protection is a straight forward process. The table below presents the calculation for the downside protection showing the break-even stock price for each option. Note that the in-the-money-option TIE AE has more downside protection that the out-of-the-money option TIE AF. The break-even price is determined by dividing the total stock cost by the shares held.

Downside Protection: TIE AF

 

 

Downside Protection: TIE AE

 

Net Investment

 $  7,265.65

 

Net Investment

 $6680.65

less dividends received

 $      30.00

 

less dividends received

 $     30.00

Total stock cost

 $  7,235.65

 

Total stock cost

 $6,650.65

Shares held

300

 

Shares held

300

Break-even stock price

 $      24.12

 

Break-even stock price

 $     22.17

Percent down side protection

 

 

Percent down side protection

 

Initial stock price

 $      25.00

 

Initial stock price

 $     25.00

less break-even stock price

 $      24.12

 

less break-even stock price

 $     22.17

Points of down side protection

 $        0.88

 

Points of down side protection

 $      2.83

Percent down side protection

3.5%

 

Percent down side protection

11.3%

Return if Exercised

Next you should determine the actual return if the option is exercised. This is where the shares are assigned, which would take place if the share price was at or above the strike price and the option is at or very close to the expiration date. The stock price must rise to the strike price in the out-of-the-money option TIE AF.

The table below presents the calculations necessary to compute the return on investment, if the shares are exercised for each option. The gain for option TIE AF is due primarily to the appreciation in the stock price. This calculation provides the expected returns you would receive, if the options are assigned and the stock is exercised.

Return if exercised: TIE AF

 

 

Return if exercised: TIE AE

 

Stock sale proceeds

 $ 9,000.00

 

Stock sale proceeds

 $7,500.00

less stock sale commissions

 $      10.50

 

less stock sale commissions

 $     10.50

Plus dividends earned until expiration

 $      30.00

 

Plus dividends earned until expiration

 $     30.00

less net investment

 $ 7,265.65

 

less net investment

 $6,680.65

Net profit if exercised

 $ 1,753.85

 

Net profit if exercised

 $   838.85

Return if exercised

24.1%

 

Return if exercised

12.6%

Days to exercise

       56

 

Days to exercise

        56

Return if Stock Price is Unchanged

The third factor to evaluate is if the stock price is unchanged. That is the underlying stock price is unchanged as the option nears expiration. This allows the investor to more fairly compare the out-of-the-money and the in-the-money covered call writes. In this case, note that the out-of-the-money option TIE AF returns 3.8% in the 56 day time frame, while the in-the-money-option TIE AE returns 12.3% over the same time period.

Return if unchanged,  option expires: TIE AF

 

Return if unchanged, option expires: TIE AE

Unchanged stock value

 $  7,500.00

 

Unchanged stock value

 $7,500.00

plus dividends

 $      30.00

 

plus dividends

 $     30.00

less net investment

 $  7,265.65

 

less net investment

 $6,680.65

Plus stock purchase commissions

 $      10.50

 

Plus stock purchase commissions

 $     10.50

Profit if unchanged

 $     274.85

 

Profit if unchanged

 $   859.85

Return if unchanged

3.8%

 

Return if unchanged

12.9%

Total Return with Buy Back of Covered Call

The final factor to consider is the potential return if you buy back the covered call option before it expires. In this case, you decided not to wait until the option expires before closing out the position. Maybe you have received most of the time premium in the option and do not want to take the chance it will be assigned, as it nears expiration. You will reduce your overall return, since you must now spend some of your capital to buy back the option to close it. The amount used in this case is an example. The amount can vary due to a number of circumstances that will cause the amount you must spend to vary.

Return if unchanged, buy back option: TIE AF

 

Return if unchanged, buy back option: TIE AE

Unchanged stock value

 $  7,500.00

 

Unchanged stock value

 $7,500.00

plus dividends

 $      30.00

 

plus dividends

 $     30.00

Minus cost to buy option

 $      30.00

 

Minus cost to buy option

 $   360.00

Minus option buy commissions

 $      10.50

 

Minus option buy commissions

 $     10.50

less net investment

 $  7,265.65

 

less net investment

 $6,680.65

Profit if unchanged

 $     223.85

 

Profit if unchanged

 $   478.85

Return if unchanged

3.1%

 

Return if unchanged

7.2%

The Bottom Line

Using the total return approach when writing covered call options, offer investors a way to increase the overall return on their investment as well as provide some down side protection. When learning to write (sell) a covered call you should carefully consider the potential for the stock price to rise or fall over the time period of the option. Out-of-the-money and in-the-money options offer investors alternative ways to enhance their position of the underlying security. Be sure to consider both the up side as well as the down side when using covered calls when trying to beat the market.

If you want to learn more about using options consider reading Options Made Easy: Your Guide to Profitable Trading (2nd Edition) by Guy Cohen. It is a good way to help you to get started learning how to use put options to reduce your down side risk.

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