Ever thought about putting your shares to work? Then the Covered Call trade is worth investigating. In this strategy you are buying or you already own shares and you are looking to bring in some additional income by selling Call options against those shares.
This strategy is best implemented in a bullish to neutral market where a slow rise in the market price of the underlying stock is anticipated. This technique allows traders to handle moderate price declines because the Call premium you receive reduces the overall cost of the shares. Since you are counting on the time decay to render the short call worthless, you do not want to sell a Call with more than 45 days to expiration.
Normally you would sell Calls at least one strike price above the initial cost of the shares. By doing this you would still have a profit on the trade should the shares suddenly gap up past the short Call strike price and you were forced to sell your shares at that strike price. Part of this strategy also, is to buy back your short Calls as their value diminishes through time decay.
Let’s look at a Covered Call trade on Tabcorp Holdings (TAH). This company has been beaten down severely lately and after bouncing off the $8 level is now showing up as an Elliott Wave 5 Buy in ProfitSource. Volume on the shares is a little above average and the Elliott Oscillator is rising.
Chart 1. TAH showing Elliott Wave pattern.
click to enlarge
This will be a fairly short term trade of only 16 days as far as the options are concerned. I decided on these options because they are still offering a good premium due to the volatility in the market, but they will suffer rapid time decay.
I’ll open the position by buying 1055 shares of TAH @ $8.65 and then sell one September $9 Call option contract for 15 cents. That will bring in a credit of $158.25 (1055 x 15c) but remember, not all contracts contain exactly 1000 shares. This will lower the actual cost of the shares to $8.50.
Chart 2. TAH Risk Graph
click to enlarge
Now, should the price of TAH go past $9 before the September expiry of the options, I can elect to buy back the September option contract, while at the same time selling an October option contract at a higher strike price to bring in some more income. This is known as rolling the option position up (to a higher strike price) and out (to a later month).
The other action I can take if TAH is trading above $9 at expiry is to do nothing and let the buyer of the option contract exercise his right and force me to sell the shares to him at $9. This would still give me a profit of $508.25 in 16 days, less brokerage.
The ideal scenario for this trade would be for TAH to rise to slightly less than $9 at September expiry. Then the short September Call options would expire worthless and I could sell the October $9.48 Call options to bring in more income.
Remember, you always have options.