Options - Covered Calls & Options Trading

A covered call is where a stock investor sells a call contract in the options market based off their ownership of at least 100 shares of stock in order to collect a premium or generate some income over time. This is a slightly bullish to neutral strategy and in general a pretty conservative options strategy.

Options trading is definitely not for everyone, as it can get infinitely complicated the more option trading strategies you encounter, however selling covered calls is an options strategy I feel most investors should at least consider. While it is true options can be very dangerous due to the leverage they let you employ, they can also be a great way to manage risk as owning virtually any stock has the potential for great risk and the danger of losing a lot of money.

Take GE as a great example, a stock that used to symbolize a "safe" stock with a steady dividend that had been paid since 1899 and increased every year for the last 32 years. That is until my favorite CEO Jeff Immelt and 2009 as Immelt cut GE's dividend by 70% and GE briefly touched $5.73 a share. If you bought GE in the year 2000 at around $60 a share and held it a the way down I guarantee you were not very a happy investor and realized that there are no "safe" stocks anymore and buy and hold is truly dead in today's modern markets.

I still favor buying stocks over selling or shorting stocks as the market over time does statistically generally go up over 10% a year, however stocks like GM, Lehman Brothers, Bear Sterns, AIG, GE, Citigroup and many,many others reinforce my view that you have to be involved and nimble in your stock choices and investing strategy. Unless you are a very short term trader, I think covered calls might a great way to help increase your returns and reduce some risk in these markets where no one really knows where its going to next.

Let's say you want to buy GE and sell a covered call right right after you buy it (also called a buy-write strategy). In order to sell a covered call you need to first purchase 100 shares (100 x $16.44 Friday's closing price= $1644.00), and then sell the covered call next (you will need to fill out a form with your brokerage to get level 1 options trading privilege) where you will collect premium for giving the call buyer the right to your 100 shares on a given date (expiration date) and a given price (the strike price). For example, if you sold the February $17 call you would collect $30 in premium (1.8%) by giving up any further gains in your GE stock above $17 a share for roughly the next 4 weeks.

This current contract expires on 2/20/10 so ideally you want GE to close a little bit below $17 by the 3rd Friday on next month. If GE closes below 17 you keep your stock and the premium as that call contract expires and becomes worthless and you can then sell another covered call. If GE closes above 17 at that time your shares are "called away" and you basically are selling your shares for $17 (3.4% gain, 5.2% when you add in the premium you get to keep). Unfortunately, if GE makes a run to $20 by that time, which is unlikely but possible, you do not get to participate in that move above 17 in this situation. You also have no protection to the downside besides the premium collected which lowers your cost basis on your original GE position. If you are looking for some downside protection buying a put or put spread might make sense however that is a much more complex options strategy and too much to delve into too deeply here.

There are also other strikes you can sell depending on your time frame and view of GE and how bullish you are on GE. The March $17.50 strike currently pays about $32 (1.9%), the June $17 pays $90 (5.4%), or even the January 2011 $17.50 strike (if you're very neutral about 2010) pays about $140 (8.5%, or about an 11% gain for the entire year provided Immelt leaves the dividend alone).

If you'd prefer not to sell your stock on expiration you can also "roll out" of your covered call which means buying back the current call and selling a different month and possibly even a different strike.  However until you really study covered calls and get some experience with them you probably want to stick to the basics as it can get really complicated the deeper you delve into the world of options trading.

So all in all, while covered calls aren't for everyone, I do think its a wise strategy for many longer term investors to employ. While the market is telling us things are much better than one year ago, I think we still need to be very cautious in our investing methods for many years to come.