Call Option Trading Secrets » Money

How to Make Consistent Profits Futures Trading

admin — Fri, 22 Jan 2010 05:30:22 +0000

The issue of direct access is an important one and it becomes more important the more short term your trading is. The market can change from a state of seeming paralysis to one of shocking volatility and activity in a flash. The length of time it takes between you deciding to enter an order and the order actually being in the market is obviously important.
When I first started trading I used a phone broker and was dismayed that my fills would often be so far from the price the market was trading when I first entered the order.
The first time I visited the trading floor, I discovered why. When I called in an order, first my discount broker would check my account equity, then he would call a phone booth on the floor, the phone broker on the floor would then write the order down and pass it on to a booth next to the appropriate pit, at that booth my order would be written down again and then signaled to a broker in the pit to be executed.
As you can imagine this would take quite a long time, even longer of course if the market was very active, as this would mean that the broker in the pit would be too occupied to take new orders. Compare this to my experience of trading as a pit trader. In the pit I was in the heart of the market and could observe every single order as it was executed (there was no delay in my price feed!).
To initiate a trade, whether it was to buy or sell at the market, or join the bid or the offer, all I had to do was open my mouth. You can start to see the huge advantage that trading on the floor gave me over off floor traders; and that doesn’t take into consideration the fact that my round trip costs fell by 96%.
Now the floor no longer exists, not in Europe at least, so why talk about the advantages of pit trading? Well the level playing field is now open to all, but very few take advantage of it. Trading with an electronic trading platform is exactly the same as trading in the pit, except I can sit down, it is much quieter and there are no crude jokes flying around.
I can trade with the click of a mouse; my order shoots to the exchange, enters in the market and appears back on my screen before I have time to blink. I think the advantages of direct access trading are clear and any futures trader still using a phone broker should move to direct access, they will also find their commissions are less (around $8 for private client traders).
The next question that arises is why trade futures? That is an important consideration given that there are a variety of alternatives vying for your trading capital (spread betting, CFDs and options), but in my opinion, futures are the only option (no pun intended) for successful short term trading.
A lot of traders are trading the stock indexes like the FTSE, the DAX, the S&Ps, NASDAQ and the DOW, but rather than use futures they are using spread betting firms. The reasons for using these firms is that they require very small amounts of capital to get started, a trader can trade very small amounts (like $1 a point on FTSE as opposed to $10 for FTSE futures) and these firms make opening an account so easy.
I understand the lure of being able to open an account with very little money and trading small amounts, but I have some serious considerations about using spread betting as a realistic vehicle for professional trading.
The two biggest selling points are no commissions and no capital gains tax. There are many different costs to trading, commissions are one and the spread is another (especially when you have to trade at the market as you do with spread betting, with futures you have the choice of joining the bid or the offer).
Commissions are important for an active trader and as an active trader you can get them very low, but lets assume they are $8 per round turn for futures and lets assume that the spread in FTSE futures is an average of 2 points. If the spread with a spread betting firm for FTSE is 6 points and assume that we are trading $10 a point we can compare the two trading vehicles.
Last week I made an average of 2.42 points per contract traded and I traded 48 times. That is, for each contract I bought and sold I made $24.20 before commissions, assuming my commission rate is $8, I made a profit of $16.20 per contract traded, which is $777.60 net profit if my average size per trade is one contract.
Had I had the same success trading with a spread-betting firm, with a 6-point spread, I would have lost $1718.40! Now I would rather pay tax on a profit that no tax on a loss.
There is one other very important reason for trading the futures market rather than a non-exchange traded market such as those offered by spread betting firms. The futures markets are exchange traded and this means that they are fully transparent, i.e. everything is visible and above the table, I can see every single trade that happens. Imagine the trading pit, as it used to be when traders stood physically in a ring trading with each other.
When a trade is entered, the order goes into the pit and is represented there, free to be taken by any other market participant. We can all see what is happening, we trade with the same information and with the same advantages/disadvantages.
Now assume you are a trader who can only trade with one broker in the pit, you can trade as much as you like, any size you like, but he sets the spread he is willing to offer you and you have to trade at market (i.e. buy at his offer and sell at his bid). This broker doesn’t want to loose money, naturally, so he always makes his spread wider than the real market spread, he also, naturally, puts his interests before yours, so he won’t always be willing to trade when the market is moving fast and he is uncertain.
Remember whenever you make money he loses, so he is very careful to maintain his advantage at all times. Who wouldn’t want to be in this brokers position (he isn’t really a broker, though he claims to be)? When you trade with a real futures broker, all the broker does is facilitate your trade; he gives you the ability to have you orders represented in the pit. A real brokers concern is that they execute your order as efficiently as possible, that is their job, they do not take positions and they do not take the opposite side to you.
They naturally want you to make money because by making money you become a client who will continue to pay them commissions. Trading with a spread betting firm is absurdly costly, spread betting firms are like amusement arcades, they can be fun, but to imagine you are going to make your living from slot machines is illusory.

Option Trading: Thinking “Outside the Box”

admin — Mon, 04 Jan 2010 17:26:14 +0000

Wouldn’t it be great if we could buy an option with five months left until expiration and sell an option with 2 months left until expiration for the same price? You couldn’t lose. Well we can’t. I love options spreads so much I realized something very important. We can buy a spread that has a lot of time value left at almost the same price as we can sell one with less time value left. The reason really opened my eyes and gave me new insight into options. Here is what I came to realize.
I started comparing how expensive options were in relation to the other strike prices in the same month and to the other months. I wanted to know based on th e price per day which options were more expensive.
The first 1 or 2 option months, as everyon e knows loses time value quickly. The at the money strike prices are very expensive compared to the out of the mon ey strike prices. Since there is not that much time left, how much can they charge for an out of the money option? Not much.
The next several months, the opposite is true. Compared to each other, the strikes that are closer to the money are cheaper in terms of price per day than the options further out of the money. Let me explain it another way using the S&P market.
6 days left at the money option cost 12 points
6 days left out of the money option cost 2 points
70 days left at the money option cost 43 points
70 days left out of the money option cost 29 points
There is more than 10X the time left but the 70 day at the money option (43 points) is only less than 4X the price than the 6 day at the money option (12 points).
The 70 day out of the money option (29 points) is almost 15X the cost of the 6 day out of the money option (2 points) but only has 10X the time value. We will buy the cheaper options and sell the more expensive ones.
Sell 6 day at the money and sell 70 day out of the money. Buy 6 day out of the money and buy 70 day at the money. This will be done for a 4 point debit. We are now buying a spread that has 10X more time value than the one we are selling and are only paying 4 points for it.
When the 6 day options expire we can sell the next month to take in more premium, still keeping the 70 day option spread.
What goes up, must come down! We have all heard this befo re in reference to the laws of Gravity. We have laws in the commodity markets as well. What comes down, must go up! The greatest traders of our time like War ren Buffet know this. He is perhaps the greatest Stock trader ever. He had never traded commodities until a few years ago. He bought silver in the futures market. When the market went even lower he bought more. The “smart money”, commercials will not be scared into selling when a market they have purchased drops even further. They know better than anyone that a commodity has real value and will always be worth something.
There is a famous book, “You Can’t Lose Trading Commodities”. The author buys commodities and then just waits for the market to go higher. He would purchase more as the market fell.
You need a big bankroll for this. Personally I know corn won’t go to $1.00 but what if it did? I want to minimize the risk in case I want to end the trade.
I started trading the Soy Complex this way several years ago. Not with options. Strictly futures. I bought what was similar to a crush spread. I increased the contracts as the market went against me until the spread rebounded a little. Since I increased the contracts I didn’t need the market to come back to where I started. It only had to rebound to the next level.
Black Jack players did this until Casinos caught on and put limits on bets. It is a known fact that futures traders make good gamblers and professional gamblers make good futures traders. I am against gambling but even gambling done with a system is not really gambling.
These card players would bet something like this: $5 lose, $10 lose, $20 lose, $40 lose, $80 win. The losses add up to $75. They would win $80, so the profit is $5. Not a lot, but they would do this all day. Black Jack is just under 50% probability for the player.
The problem is there is a slight chance that you could lose 40 times in a row. Now with Commodities we have a 50% probability and we won’t lose 50 times in a row because the market can’t go b elow zero.
Now before I go an y further, I need to tell you that I am not recommending you double down on your trades. What you can find are mark ets that are near their lows where you can do a small scale trade. Spreads offer even better opportunities. They have a closer range (high to low).
By now you can see we only use this to go long a market since we can never b e sure how much a market can go higher. First we need to find a market that is low already so we won’t have to wait that long and also so there will be less capital needed. I prefer to trade this using options. There are many ways to do this. You could buy an option in a market like soybeans and choose how many cents the market will drop before you buy more. The problem is, an option is a wasting asset. The Theta (time decay) would cause you to lose money.
I use spreads so I am not paying for time decay. I will probably sell more Theta than I buy, so if the market does nothing I will make money just on time decay.

George Fontanills Incorporates Options to Lower Risk

admin — Sun, 27 Dec 2009 05:33:08 +0000

Trader George Fontanills first began utilizing options in order to go “delta neutral” on his futures positions, which would allow him to “still sleep well at night.” Since he began using options in conjunction with his futures trading, Fontanills believes he has found a way to accelerate his profits while decreasing his risk.
Fontanills began his professional life as a certified public accountant, but “decided that being a CPA wasn’t for me.” After earning a degree at Harvard Business School, Fontanills got involved in the real estate market, but then “the real estate market died.”
In 1988, with a few other partners, Fontanills decided to give the futures market a shot. “We hired a couple of guys. They happened to lose 10% of our money in 30 days and I thought ‘Hey, I could do that,” and Fontanills began to explore trading on his own.
In a systematic fashion, Fontanills studied the market. “I was probably one of the first users of Omega TradeStation and I started writing programs to try and figure out all the variables that were involved in a trade,” he explained.
“The first thing I figured out was that volatility and movement in a market meant that everyone was confused,” he said. To this day, Fontanills says he searches out markets with high volatility in order to place his trades.
Originally, Fontanills began as a day-trader, believing he could better control his risk in that fashion. However, he began to believe that he was missing a lot of the moves, which occurred overnight. At that point, Fontanills began to study options strategies. “I learned how to use options and how to become delta neutral so I could hedge myself in both directions and still sleep well at night and that’s when I really started to accelerate my profitability,” he said.
“Delta, by definition, is the rate of change of a price of an option to the rate of change to the price of the future,” Fontanills noted. “It’s how fast an option will change, relative to the speed of the futures.”
“Delta neutral means whether the market goes up or down, I’m in a position to make money,” Fontanills said. For example, “I’m short wheat and long two wheat calls, at the money. If wheat goes down, I’m making money on my short wheat position and eventually the rate of change will allow me to make more money on that position.”
While he notes that some traders tend to be scared away by the perceived complexity of options, Fontanills said “someone who can figure out how to make money with options can make money easier and safer than just using futures.”
In terms of fundamental factors, Fontanills said, “I don’t ignore fundamentals because I like to see what other people are thinking. Most of my money is made being a contrarian to what everyone else is thinking. The masses are usually wrong.”
In searching out his current trades, Fontanills said, “I look at the momentum of what is happening. If volatility and momentum goes to a certain level of what is way out of line, I’m looking for a reaction in the other direction and then I put on a trade … my greatest returns are made when something is really out of whack.”
The main future markets Fontanills trades are gold, oil, agriculturals (soybeans and wheat), S&P 500, interest rate markets and currencies. “I’m looking for fast, volatile markets and the S&P and bonds are definitely up there,” he said. Typically, Fontanills said his trades last “thirty days, at most.”
Advice he has for beginning futures traders: “Trade small–until you learn what you are doing. “Everyone overtrades at the beginning. I probably lost 20% of my account on my first trade,” Fontanills admitted. “Learn how to use all the methods that are out there to trade … learn how to use options, because every successful trader I know, knows how to use all instruments. Why reinvent the wheel? Follow the (methods) of people who have been successful,” he said. He does note, however, the importance of “whatever methodology you use, it has to fit your personality.”
Finally, of course, “learn how to limit your risk … if you can stay in the game long enough, you will learn how to become successful,” Fontanills said.

How Do You Sell Options To Generate Amazing Returns?

admin — Wed, 23 Dec 2009 17:26:48 +0000

In this article we will look at how to effectively implement this strategy to increase your wealth. But before we do it’s important to recognize that this strategy offers you the benefit of cash returns and easy access to your capital. Why are these things so important?
Cash returns:
Let’s look at cash returns first. The best way is probably to use a comparison to another investment alternative such as property. Too many investments don’t offer you good cash returns (only good capital returns), but your ability to generate cash is essential to achieving the freedom you need to pursue attractive wealth creation opportunities. In the UK at the moment the average rental property will generate approximately 5% return. Let’s say you need $50,000 to live each year and you have managed to accumulate $100,000 in savings.
If you decide to buy a $200,000 property and you invest your $100,000 and borrow the balance at 5% you would generate a positive $5,000 net cash return every year (assuming no other property related costs such as management fees, repairs, etc). In essence you’d have to by 10 properties to generate the $50,000 annual cash you’d need to survive. That could take a long time and in the mean time you’re spending your productive hours working for someone else to earn a paycheck to live off…and missing loads of opportunities. I love property as an investment and own numerous rental properties but it is not a great method of generating cash flow…well not without a great deal of work!
Selling options on the other hand can pay you a cash flow in the terms of a premium every month or two. It’s a regular cash flow that you can use to help you quit your job and spend your time building your own wealth rather than your employers. Using effective options strategies that generate between 30% and 50% returns per year would earn you $30,000 to $50,000 per year off your $100,000 savings in a regular monthly income. This would give you incredible freedom and independence to spend your productive hours working for you not an employer. This is the importance of cash flow.
Access to capital:
The second key thing to remember is that options allow you quick access to your cash. Property in contrast takes many months and large costs to realize your cash investment. Your option investments require you to place initial margin with your broker to cover the risk of potential losses, but since your options expire every month or two you receive your initial margin cash back each time. Also it is really easy to buy or sell your options back at anytime at a very small cost (commission) to gain immediate access to your cash if you need it. This is often one of the main benefits cited by Wall Street to investing in stocks.
So now that you know two crucial reasons why options are vital to your wealth creation arsenal it is time to examine option selling strategies…
Option selling:
I like to use an example as a way of illustrating the strategy of selling options as a means to generate brilliant returns. I’ll assume you are familiar with selling calls and puts and that you know your returns are limited to the option premium you receive and that your losses are theoretically unlimited. Though I will elaborate on what this really means as we work through the example.
On the 28th March 2008 gold was trading at $932 an ounce. The June 1 $700 put was bid $0.90 which means that each option is trading at $90 (i.e. 100*$0.90). Now at this stage it helps to actually have a view on the instrument you are trading. In the case of gold I have been extremely bullish for a long time due to a number of factors including the high U.S. inflation rate, collapsing U.S. dollar, poor current account, falling interest rates, huge government and private sector debt etc which all indicates that investors will move their money to a “safe” investment…gold! Now the point here is that I don’t know when gold will rally nor do I know that it will rally really at all…what I’m confident on is that it won’t fall very far. This means I can sell put options confident that fundamentals mean that the price of gold should not fall from current levels…and even if it does it’s not going to fall to $700 an ounce by 1st June.
Each gold option is worth $93,320 (i.e. $932*100) so selling one option and earning $90 in two months might not sound like much but we need to look at it from a few different angles. A $90 return over two months on $93,320 is an annual 0.6% return which quite frankly is rubbish, but this is not the way to really look at this investment. The notional (face value) of the option really doesn’t matter. Why? Well because that is not what you are paying for the option. You are not really buying $93,320 worth of gold (or even $70,000 worth at the strike price), but rather a way out-of-the-money put which requires you to only pay a small initial margin.
The initial margin on one gold $700 option is about $900 which means that over a two month period I would be able to generate a $90 return on a $900 investment. Viewed this way my return would be 60% per year (i.e. 10% every 2 months)! Now that’s an amazing return…so does this mean I should rush out and sell 100 puts and generate a $9,000 cash flow over the next two months? Well not unless you were worth millions I wouldn’t recommend it. Why? Because the unforeseen can happen. Selling 100 $700 put options means that for every dollar the price of gold falls below $700 you would lose $10,000 (i.e. 100 options * $100). So if the price fell to $650 you would lose $500,000. Ouch. So what do you do?
You strike a balance. You never expose yourself beyond what your can afford to lose in an individual trade and you manage your risks via stops. Taking the $100,000 cash worth example what would happen if you sold 5 options. Well you could earn $450 in two months (i.e.5*$90) equating to $2,700 per year in income. Your initial margin to the broker would be $4,500 (i.e. 5*$90) still giving you a 60% annual return. Your risk is now $500 per dollar below $700, which is a fully manageable exposure on your $100,000 capital given the extremely unlikely possibility of gold falling that far.
The second way of managing your exposure is through stops and the KISS method is always the best method. Easy to understand and easy to implement. The two best methods I know of are:
1. to stop out when your option doubles in value against you (or triples for the more adventurous). This method is simple and effective for the more risk adverse investor. I’ve found that it’s not always the best when you are selling way out of the money options as you can be stopped out but still never really be at risk of your options being exercised, thus forcing you to take losses unnecessarily. But it is the safest route.
2. to stop out when the price of the underlying reaches your strike price. In our example your stop would be at $700. The problem with this method is that your losses would be much higher than the first method but obviously the likelihood of your stop being breached are much lower.
The strategy I usually use is to find many of these attractive deals and never expose myself too much to one trade (a lesson I’ve learned the hard way!), which will ensure you will sleep peacefully at night…just as I do! So if you take the above scenario how many trades should you place at any one time? Well you need to find a balance between putting your capital to work (i.e. your $100,00) which is used it as initial margin on trades and saving enough of it such that you can meet margin calls if positions go against you in the short term, so you are not forced to close positions or make margin calls. Again applying the KISS method is easiest and the simplest way is to put no more than 50% of your capital as margin at any one point in time. Any more than this could lead to unnecessary stress of margin calls if positions go wrong and means your positions are too large.
Taking our gold example and replicating it to other trades we could place $50,000 as initial margin which would generate a $30,000 annual return ($90*$50,000/$900*6) or a 30% annual return. I now enjoy a fantastic regular income on my cash capital through options investments and non-stressfully earn a comfortable 30% to 50% annual return on my cash capital.
The final word on gold…
Was I right about the price direction of gold? Yes and no. The price of gold (at the time of writing) has actually fallen to $882 (it has been as low as $850) so my expectation that gold would rally from $932 proved slightly wrong (or at least premature!), but was i really wrong? Well the price of my options have fallen over the past month and a half from the $0.90 I sold them to be worth virtually nothing. So even though the price of gold has actually fallen I’ve made money…wrong and still right! Options are truly an effective wealth tool.

Trading Options – The Basics (Part Two)

admin — Sat, 12 Dec 2009 06:04:15 +0000

Definition Mumbo-Jumbo
Options, unlike stocks, are derivatives. That means that their value derives from the value of another financial instrument (called the underlying). The underlying can be a stock or futures contact or an index. For the purpose of this article we’ll concentrate on stocks.
An option is a contract between two parties, the writer (the seller) and the buyer. An option gives the buyer the right to either buy or sell a stock at a pre-determined price. And so there are two types of options corresponding to those rights: calls and puts.
Example for Put Options
Say you own a thousand shares of BHP stock currently worth 30$ each. You know that reports are coming out soon but you have no idea whether they are going to be positive or negative. If positive the price will go up, that’s easy.
In case BHP reports badly you know you will be selling. But you also know that everybody else will be selling too. This will drive the price down and you will incur a loss even if our order gets filled. Now, wouldn’t it be great if you knew beforehand what BHP was going to report? If you knew and sold that would be insider trading, which is illegal and “that never happens in Australia”. The next best thing would be to secure your right to sell at the current price of 30$ per share. As we know, there is no such thing as free lunch. So, in order to secure this right, you have to pay a premium. And you need someone to sell you that right.
This right is a put option. It is a contract between you and the other guy that gives you the right to sell stock to him at 30$ no matter what. So if the stock drops to 20$ you can exercise you right to sell it for 30$. Or, if you think that the stock has reached its bottom you can keep the stock and just sell the put options you bought previously. Now think, the stock price is 20$ and you are selling the right to be able to sell it at 30$. Of course that right would be worth much more than when you bought it for (because back then the stock was at 30$). So, the more the stock drops the more valuable the put option becomes.
A pure options trader wouldn’t have any stock to sell. His goal would be to buy puts when he expects that a stock will go down. After the stock has dropped the options trader will seek to sell the option for a profit.
So you see, it does not really matter where the market goes, up or down. Trading options enables you to profit from both directions. When you expect the price to go up you can buy the shares or attain higher leverage by buying calls. Should the reverse be the case, you can buy puts. To me, puts are easier to understand than selling stocks short. And believe it or not, there are options strategies (combining calls and puts) with which you can profit from sideways movement. But let’s not get ahead of ourselves.

Creating Cashflow: Using Covered Call Strategy To Pay You Cash

admin — Mon, 30 Nov 2009 18:25:49 +0000

I’ll assume in this article that you already have the basic understanding of stocks and options. If not then it would be worthwhile to read about these investments first. The covered call strategy brings together stocks and options to form a third strategy…a cash flow strategy. The covered call strategy has a number of benefits that makes it an essential element of your wealth creation arsenal, namely it’s:
* Simple and quick to implement
* Easy to understand and track
* Produces fantastic cash returns on your capital
* Helps protect your portfolio from market fluctuations
* Fairly conservative…i.e. it’s not a high risk strategy
* A fairly hands-off investment once made which frees your time to concentrate on other things
So what type of returns should you expect from the covered call strategy? Well let’s examine the strategy and example first because this strategy has a range of possible returns. But before we rush out and implement this strategy I would like to highlight to you that the covered call strategy should only be used by those that already invest or intend to invest in stocks. Investors should not buy stocks simply to implement this strategy for one simple reason…there are better strategies available to you. That is not to say that the covered call strategy does not work for in this context…it does…it is just to say there are better strategies available. However, if you have a stock portfolio or intend to then the covered call strategy is a fantastic way of generating excellent extra income and at the same time lowering your investment risk.
Most investors simply purchase funds (whether actively managed or passive index trackers) and take a totally hands-off approach. Some more adventurous ones invest directly in stocks also in the hope that over time they’ll be able to enjoy watching their stocks rise in value. Their returns, also referred to as their payoff, is shown by a 45% line on a payoff diagram.
Informed investors…wealth creators…apply a different strategy.
The covered call strategy generates extra income by selling call options on stocks you own. You can think of it like renting your shares, much like you would rent out an investment property. Unsophisticated “investors” buy stocks and don’t rent them out. Would you buy and investment property just for it’s capital return and not rent it to someone to generate an income for you? Of course not…well the same applies to stocks.
When I say the word “options”, which are derivatives, many people instantly think risk. If you find yourself thinking these types of thoughts you don’t know options, and derivatives in general, well enough and you need to. Any investment is risky if you don’t know what you’re doing. As a former professional derivatives trader I know that derivatives need not be feared, but they must be respected. You need to thoroughly understand what you’re investing in if you ever hope to be wealthy. Ignorance is not bliss!
Selling, also known as writing, calls on stocks is not risky. It’s a conservative investment strategy. In fact, it is much less risky than just investing in stocks by themselves.
The mechanics of the covered call:
The covered call trade is a combination trade whereby you own a certain amount of stock and you sell call options of the same value. As the seller of the call options you receive a cashflow (the premium) from the buyer. You are effectively selling to the call option buyer the upside benefit of the stocks above the option strike price. You’ve agreed to sell your stock for a specific price by the option’s expiration date. They in turn pay you the premium for that benefit.
You are still exposed to the possibility of the stock price falls, but this is reduced by the premium income from the sold call, which is why it’s a more conservative strategy that owning just straight stocks.
Your potential income is also limited, as you cannot earn more than the capital increase in your stocks up to the call option strike plus the income from the sold calls. Above the option strike the buyer will exercise their option and you will have to sell them your stocks at the option strike price.
Covered call example:
Let’s say you purchased 1,000 XYX stocks for $50 each, totalling $50,000 in May and you sold 10 June $55 call options for $2.50 each, which expire 4 weeks from now. If XYZ stock goes above $55 to say $60 by the June expiry date you will be “exercised” and have to sell your stock to the option buyer for $55, which will be below the new June market price of $60.
Your compensation for this is the $2.50 premium on each call. Now the 2.50 call is actually $250 because the option in this example represents 100 shares. In the UK and Europe the multiple is usually 1,000, while the US is usually 100. Since, you’ve sold 10 options your total premium is $2,500, representing a 5% return on your $50,000 investment over 4 weeks (which is an amazing 89% annualized return!).
If the stock price falls below $50 your stock losses will be partially compensated by the extra $2.50 income from your sold options. This is why it’s a more conservative strategy than just holding pure stocks. If the stock remains at $55 you will receive your $2.50 and no capital gain returns on your stocks. Anywhere between $50, where you bought XYZ stock, and $55 where the option strike is, you will receive the same $2.50 and an increasing capital return on your stocks.
The maximum return you can hope for is always where your option is exercised. At $55 and above you will receive $2.50 in option premium and $5 in capital appreciation on your stocks. This is a total of $7.50 in 4 weeks, or 15% (which is a truly amazing 515% compound annualized return!).
Covered call variables:
The key variables are how long in the future do you sell you options, and what strike should you sell?
The further you look into the future the higher the sale price for an option. For example, in our XYX call option example the June $55 call was selling for $2.50. The July $55 call would be selling for slightly more than this, say $3.50. However, what tends to happen is that as you look further into the future the increases become smaller and smaller, so the August $55 call might only be only $4.00. So to get the maximum daily benefit from selling a call you should sell calls nearer to expiry, say up to maximum of 60 days. You can calculate and compare alternatives at the same strike by looking at the “per day” income. So in the case of our $2.50 option it would be paying us $0.09 per day ($2.50/(4*7), which is much higher than the $3.50 option return of $0.06 per day ($3.50/8*7).
The choice of strike is a more difficult question and depends largely on your view of the future movement of the stock. The higher the option strike you sell the lower the premium you will be paid, but the benefit is the less likely it will be exercised so you could earn more if the stock price increases. So where the $55 call was selling for $2.50 the $60 call might be selling for $1.00. If the price of the XYZ stock rises to say $60 you would earn $7.50 in the case of the $55 calls ($5+$2.50) and $11 in the case of the $60 calls ($10+$1).
The downside of the higher strike calls is that you loose more and more of your protection as you move to higher and higher strikes. For example, if the price of XYX dropped from $50 today to $47.50 at expiry, in 4 weeks you would have broken even on the $55 call as your $2.50 loss on the stock would be fully offset by the $2.50 option premium you’ve earned. However, in the case of the $60 call you would lose $1.50.
A good rule of thumb balance of downside protection and upside gain is to sell slightly out-of-the-money calls like the $55 call.
Another good rule of thumb is the strategy of buying your calls back if you can purchase them for 25% or less of the original sale price because the stock has fallen in price, and then reselling new calls for the original price. For example, say the price of XYZ stock falls from $50 to $45 and you can buy the $55 calls back for $0.50 and resell the $50 calls for $2.50. You have effectively increased your option return by $2.00 to a total of $4.50 almost entirely offsetting the $5 (i.e. 10%) fall in the stock price.
Covered calls for your wealth journey:
One of your key aims on your wealth journey is to generate a passive or portfolio income that will exceed your expenses. When you’ve achieved this you are no longer dependent on your job for an income and you can concentrate on building you wealth rather than working for someone else. You may not have a wealthy lifestyle but you are self-sufficient.
The wealthy sell calls on their existing portfolio, but those on the wealth journey may not have that luxury. In their case they may actually buy stocks so they can sell options to generate fantastic incomes returns. However, as I stated at the beginning the covered call strategy may not be the best option strategy to implement if you do not have an existing portfolio. That is not because it does not work, but because there are simply better strategies. However, let’s examine it anyway in this context.
Let’s say you’re able to accumulate $100,000 in cash perhaps from your investments or your home. Your $100,000 cash would allow you to buy $100,000 worth of stocks and sell the equivalent value of calls. If they generated a 5% monthly return for you, like our example, that’s $5,000 per month or $60,000 per year. This is before any capital appreciation or compounding is taken into account on your stocks. Those who want to take the wealth journey need to use strategies like this to give them the cashflow they need to live and invest, which provides you with the freedom to concentrate on finding more income producing opportunities.