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The Basics of the Call Option plus a Current Real Life Example

Definitions:

Implicit in the term covered call writing is the fact that we are selling call options. They are covered because we first own the underlying equities prior to selling the option. Since this is my first article of the new year and given the fact that we have so many new members of the Blue Collar family, I felt it would be prudent to review the basics of the call option. I will follow this up with a video of a current example taken from the IBD 100 list.

The seller or writer of the call option (that’s us) gives the buyer or holder of the option the right, but not the obligation, to purchase our shares (usually in 100 share increments), at an agreed upon sales price (strike price), by an agreed upon date (expiration date). In return for undertaking this obligation, the option writer receives a premium. This option is termed a call because the holder can “call in” the stock at any time from the sale of the option to expiration Friday (the 3rd Friday of the month that the option expires).

The Option Contract:

The option sets the terms of a contract about a possible future transaction involving the underlying stock. Since the option value is directly related or derived from that security, options are said to be derrivatives. When the holder of the option makes use of the right granted by the option, the contract is said to be exercised. It is important to remember that until that option is exercised (it may never be exercised) the option writer retains all rights conferred by stock ownership. For example, if a dividend is distributed prior to the security changing hands, the option seller will enjoy those profits.

Here is the information contained in  a call option contract:

Sell 2 XYZ February 50 Calls @ 2

We are selling some unknown option buyer (who we never meet or speak with as all transactions are accomplished online) the right, but not the obligation, to purchase 200 shares of company XYZ @ $50 by the 3rd Friday in February. In return for undertaking this obligation, we will generate $200 (less commissions) into our account immediately upon that sale. Except for the premium which changes with various market conditions, all other elements of the option contract are set by the Options Clearing Corporation (OCC).

Options are traded by auction on exchanges including some stock exchanges (recently ther NYX became a major player in this arena when it purchased the American Stock Exchange). Unlike stocks, options are NOT issued by individual companies (Google does not issue Google options). Instead, the OCC, which is jointly owned by the exchanges and regulated (I use that term loosely!) by the SEC, issues all options. The OCC standardizes option terms and keeps track of buyers and sellers to guarantee that both parties meet their obligations.

The Premium or Value of the Call Option is determined by 2 factors:

1- Intrinsic Value: This is the amount the holder will gain by exercising the option. It is the difference between the stock’s market price and the strike price. For example, if the stock is selling at market for $53 and the strike is $50, there is $3 of intrinsic value in the option premium.

2- Time Value: Depends on the time left before expiration. It is the total option premium minus the intrinsic value. In the above example, if the option premium was $5 and $3 was intrinsic value, then the time value would be $2 ($5 – $3).

Behind both intrinsic and time value are several market and economic factors as well as investor expectations. Here is a link to an article I published in July that explains many of these influences:

/blog/the-factors-that-determine-the-value-of-your-option-premium-plus-our-readers-pick-their-favorite-stocks/

The Call Option as it relates to the strike price:

1- In-the-money: The market price of the stock is higher than the strike price of the option. This is the only situation where we have intrinsic value. Example: stock price is $53; strike is $50.

2- At-the-money: The stock’s market price is the same as the option’s strike price.

3- Out-of-the-money: The stock’s market value is lower than the option’s strike price. Example: stock price is $48; strike is $50.

Opening and Closing a position:

When we sell (write) a call option, it is referred to as opening a position. Since we sold the contract we are said to be opening a short position. The holder (buyer) has opened a long position. We, as the option seller, can close our position by purchasing the same contract. That will cancel the original sale and now you will own the stock long. Buying back options contracts is the basis for our exit strategies which can be found in chapter 11 of my book, Cashing in on Covered Calls. More on exit strategies later in this article.

Important upcoming events:

IBD is enhancing its website:

I recently posted the fact that this site will be upgraded and slightly change our screening process. I have been in touch with the technical and educational departments of IBD regarding these changes. I am also in the process of testing hundreds of stocks with the enhanced version. My conclusion thus far is that the new screening process will be easier, more time efficient, and as accurate as the original screen. All those on my mailing list will receive a free update on the enhanced screen. Those of you not on my mailing list but would like to join, use the following link:

/joinlist.shtml

I promise you that the changes will be easy to follow and on the money (pun intended). I will send the upgraded information when the site changes are made which should be in February or March (I am told).

My next book on exit strategies is headed to the publisher next week:

Thanks to your feedback, I was motivated to write (what I believe to be) the only book ever written totally devoted to the subject of exit strategies for cc writing. I am putting the finishing touches on the manuscript and will be sending it off to the publisher next week. I anticipate that the book will be published and available to the public in the spring. After publication, I plan to host a seminar on this subject which will be professionally filmed for purposes of creating a DVD and CD series on this subject. I will keep all those on my mailing list informed of dates and times.

Last Weeks Economic News:

Two negatives and a positive describes the last week of the year. On the downside was an economic report indicating that manufacturing had contracted substantially and another that reported consumer confidence at a historic low. On the brighter side, the stock market began the new year on an up note: the S&P 500 rallied 6.8% to 931.80.

Market Tone:

The Volatility Index continues to decline to 39 (a positive) and the S&P 500 is trading above its short-term moving average, also a positive. Can things be turning around? This market is still news-driven and we need all that cash on the sidelines to start filtering back in. But for now, it appears that the market could be bottoming. We’ll continue to monitor market tone on a weekly basis until we are confident that market conditions have turned around. Here are the charts:

VIX: 1-2-09

VIX: 1-2-09

S&P 500: 1-2-09

S&P 500: 1-2-09

Selling a Covered Call Option- Current real life example:

I’ve made a video (Spielberg, I’m not!) of how easy the Cashing in on Covered Calls system is. ALL CALCULATIONS YOU SEE IN THIS VIDEO ARE DONE FOR YOU AUTOMATICALLY BY THE ELLMAN SYSYEM OPTIONS CALCULATOR (ESOC). I hope you enjoy it:

Wishing you all a healthy and prosperous 2009.

Alan

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

9 Responses to “The Basics of the Call Option plus a Current Real Life Example”

  1. admin January 4, 2009 8:46 am #

    Email question from Don:

    Alan,

    Sometimes there is a discrepancy (albeit slight most of the time) between earnings dates provided in the IBD 100 listing and the Yahoo site. Do you have more confidence in one over the other?

    Don
    ________________________________
    My response:

    Don,

    My favorite site for earnings dates is:

    http://www.earningswhispers.com

    The reason is that it let’s you know when the estimated date is confirmed . Companies give approximate dates and change it from time to time so the online dates are approximate until confirmed.

    Another is:

    http://moneycentral.msn.com/investor/market/earncalendar/

    When the date is near a contract period and you are not sure if it will conflict with an option sale, move on to another stock.

    Alan

  2. WW January 5, 2009 9:25 am #

    In your year end update, it sounded like you were not currently trading cc’s. At what point will you jump back in (ie confirmed uptrend)?

  3. admin January 5, 2009 9:51 am #

    Bill,

    Good question. As previously posted, I stopped selling options mid-2008 due to the market turbulence and precipitous decline in most sectors.

    On page 4 of my book, there is a diagram of market conditions appropriate for cc writing. In my view, the current one (that’s the one with the arrow heading south!) is not. I have been including weekly charts of the S&P 500, the VIX, and certain key industries so we can all evaluate market tone.

    Things have improved somewhat of late, but I am still not comfortable jumping back in yet. However, when confidence returns to the market (instiutional investors), there is a ton of cash on the sidelines that can take us on a fun ride back up.

    Alan

  4. admin January 6, 2009 2:07 pm #

    Another victim of the Madoff scandal?

    Could we see an end to the SEC? For failing to detect the world’s biggest fraud the SEC is on the defensive:

    The Times reports that at the first of a number of Washington hearings, held by the House of Representatives sub-committee on capital markets, senior lawmakers sought to examine how the SEC had failed to detect Madoff’s alleged $50 billion Ponzi scheme and to consider how America’s financial regulatory framework should be redrawn under the Obama administration.

    Paul Kanjorski, the chairman of the sub-committee, said that he wanted to know how such an elaborate Ponzi scheme had “fallen through the cracks”, adding that the scandal represented an opportunity to restructure America’s entire regulatory system.

    David Kotz, the inspector-general of the SEC, who is leading an inquiry into its role in the Madoff scandal, said that he had seized documents from the office of the chairman of the SEC, Christopher Cox, and had also demanded e-mails from former and current employees.

    I have been critical of this agency since the days of Enron, Tyco, Worldcom and the like. It took this Madoff Ponzi scheme for Congress to get serious about our protective agencies.

    One problem is the lack of an adequate number of investigators. But another is that the attorneys on staff oftentimes move on to the more lucrative field of investment banking , the very folks they are asked to regulate.

    So, perhaps this tragic fraud will have one silver lining….a new or improved regulatory agency that will be effective in creating the transparency necessary to allow us to invest on a level and honest playing field.

    Alan

  5. admin January 10, 2009 8:21 am #

    Industries to watch:

    Two industries that have been attracting some institutional interest of late are the Coal and School industries. I will be highlighting one of the stocks in the School industry in my next blog publication.

    Alan

  6. Barry Bergman January 19, 2009 7:10 am #

    Alan,

    I wanted to let you know how well the exit strategies have worked for me. Specifically, I want to discuss Pfizer. I originally sold the Pfizer (PFE) $17.50 Put. the stock was Put to me with a net cost to me of $16.10 (after receiving the Put premium). I then sold the Jan $17.50 call. As expiration approached, I wanted to keep the stock…so i was watching it closely on Friday.

    I bought back the PFE Call for $0.07, giving me a nice return as well as not having any Call outstanding. The stock closed at $17.52 on Friday. If I didn’t execute an “expiration Friday” strategy, the stock would have been call away from me. I will be selling a new Feb call on PFE tomorrow, allowing me to continue a nice revenue stream from this stock.

    Barry

  7. Linh Xie March 16, 2012 7:55 am #

    Do you have to have a program like Jungle Disk to use S3? I’m not savvy on all of this, just want to figure out as much of this as I can before I sign up for anything!

    • Alan Ellman March 16, 2012 8:22 am #

      Linh,

      Most of the information on this site is FREE. I would suggest you look into the Beginner”s Corner video series for starters. The videos and powerpoints are all free. Should you decide to become a premium member, the membership is based on a monthly commitment. You can opt out at any time (we hope you don’t!). The first trial month is only $9.95. We make it as easy as possible for new members to learn about this great strategy. We also provide this information at the lowest possible cost especially compared to other sites.

      Alan

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