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:

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