A Safer Way to Invest
Is it possible to make a stock investment without running the risk of loss? I guess on one side of the equation the obvious answer is no, but I am going to show you how to get as close to a "No-risk" investment as possible while still earning 20% or more a year. The best news of all is that it does not take a lot of money to accomplish what I will be discussing in this Hub.
For a long time I never considered doing Covered Calls because I thought they were pretty boring trades with limited profit potential. However, I have learned that they are actually a very fun trade that produces very consistent profits, with very minimal risk even if the stock makes a sudden and dramatic drop in price.
What I am going to show you in this Hub can be done with as little as $2,000.00. The power of this strategy is that if you start with a $10,000.00 at the end of five years you can grow your account to over $26,000.00.
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Structuring the Trade
Above I stated that this trade could be done with as little as $2,000.00. Every brokerage account will has it's own minimum funding level, but I know that Optionshouse has a minimum funding of $2,000.00 for a margin account. Opening an account in this amount will give you the ability to safely trade up to about $3,500.00 in stocks.
While I am not recommending Optionshouse, I will be using them as my example. I personally have one of my accounts through them. While their order entry tools have some limitations, the strategy I am going to discuss in this Hub works great on their platform. In addition they have a very competitive commission structure along with a free tool that will help you identify potential trades.
The Covered Call or Covered Write is considered one of the safest strategies when one trades stocks and options, but there are ways to structure the trade that can help prevent losses even when the price of the stock drops dramatically.
As I write this Hub I just paused and signed into my Optionshouse account. I want to walk through some potential "real" trades. I selected the "tools" tab and then selected the Covered Call tool. This opened a window that listed 20 potential Covered Call trades that had the potential of 53.2% to 133% potential returns. The stock prices range from stocks that are currently trading for a little over $7.00 a share to nearly $105.00 per share.
I am going to assume that the account we are using is the smallest account of $2,000.00 (+margin) so we are going to pick AMR, a transportation stock that is currently trading for $9.39 and we will be selling an April 9.00 Call for .92 cents.
Let's start off with our Call options. Buy selling a $9.00 Call we have agreed to sell AMR at $9.00. Your first reaction is why would we buy a stock for $9.39 and agree to sell it for $9.00? The answer to that question is for the .92 cents we will receive. Remember an Option represents 100 shares of stock so when i say, ".92 cents" you have to multiply that by 100, which is $92.00.
Let's work through the trade and see how this plays out. First of all it is the first week of March that I am writing this Hub and the Option we will sell will be the April Option. Therefore, this plan in the best case scenario will only last until the 3rd week of April, which means this trade should only last about 42 days.
We will place our order as one transaction that represents the buying of the stock (lots of 100 shares) plus selling Call options (1 Option per 100 shares purchased). Our stock price is currently $9.39 cents, which means we will pay $939.00 for every 100 shares of stock that we purchase. We are willing to trade up to about $3,500.00 (leaving room for some draw downs) so we would probably elect to purchase 200 shares with 2 Call Options. This would utilize just under $1,700 of our $3,500 leaving us enough room to have two different trades in our account. For simplicity sake we will only use 100 shares in our example.
Constructing the Trade:
We are going to place an order to purchase our stock for $9.39 while selling an April Call (strike price $9.00) for .92 cents. Understand what we have done, by selling the Option we have obligated ourselves to sell the stock we just purchased for $9.00 per share. As long as the stock is trading above $9.00 per share. So how do we make money?
Stock purchase price: $9.39
Stock Sells price: $9.00
Net Difference: ($ .39)
Call Premium Received $ .92
Net Profit on Trade $ .53
Remember that these numbers represents the "per share" price and you have to multiply them by 100 to get the true dollar amount. Our net profit is .53 cents on a $9.00 investment. That's a 5.9% return in 42 days. In the best case scenario you will only be in this trade for 42 days, which means that you can do this trade 8 times a year. Using this trade as our example average 5.9% in 42 days gives us the opportunity to make 48% a year. Making 20% a year is actually quite easy and safe. Let me show you what happens when things go wrong.
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When Things Go Wrong
What happens when the stock doesn't perform like we thought it would? This is a bullish trade meaning that we want the stock price to increase so that we are called out of our stock position. However, sometimes stocks go down in price. What happens then?
We purchased our stock for $9.39, but received .92 cents for the Call we sold. If we subtract the premium from the stock price we will find that our cost basis for this stock is $8.47 (9.39-.92). This means that the price of the stock can drop to $8.47 before we start to loose any money. Let's look at a couple of scenarios should the price of the stock fall below $9.00 per share and we are not called out of the stock.
Let's say that the stock ends up below $9.00 but above $8.77. In this scenario our Call Option will expire worthless meaning that we get to keep the full .92 cent premium as profit, but we are negative on our stock price, but we still have a net profit because we are above our break even point of $8.47. Most people at this point simply sell the stock and keep whatever net profit they have, but why do we want to do this? Why not sell another Option? Depending on the premium of the next Option we sell our cost basis will drop even more. We simply look at the Option chain at the next months expiration and see which prices work best for us. Let's say we collect .75 cents on the next Option we sell. Our cost basis has not dropped to $7.72 meaning that the stock will have to fall below this price before we loose any money.
Let's say our $9.39 stock gaps down on some really bad news and is now trading below our $8.47 break even point. Let's say we drop all the way down to $7.75. That would be something like a 17% drop in one day. That is a pretty dramatic move, but it can happen.
First of all we realize that the Call we wrote has dropped in value also (that's profit for us). In fact, there is a good chance that it has lost a pretty significant portion of it's value. All we have to do is place an order to buy back our Call (realizing most of our profits) and then sell a new Call ($8 Strike). If the stock closes over the $8.00 strike we will be called out again, if it closes below the $8.00 strike we will keep all of the premium and then do the same thing all over again.
By paying attention to the Option prices and what the stock is doing we just keep structuring trades around our trades to keep them profitable. If we do a little technical analysis before we get into the trade prior to placing our orders most of our stocks should do what anticipate. For those that don't we just keep using Options to create a lower cost basis that will allow us to eventually realize our profit or at least keep our loss to a bare minimum.
Benjie on February 10, 2012:
I think the important factor is the call premium. how is this set?
The Rising Glory (author) from California on March 06, 2010:
Side Note: In this strategy you profit comes from the Option premium collected not from the stock itself. We are just using the stock for the purpose of selling the Call. One could just sell a Call without owning the stock, but the margin requirement are much higher in that instance.
The Rising Glory (author) from California on March 06, 2010:
Simply put, an option is a contract between two parties that include an underlying stock, a strike price, a specified date, and a premium. These options come in two forms, "Puts" and "Calls".
Since there are two parties involved one person "sells" the option and the other "buys" the option. The seller collects the premium and the buyer pays the premium.
The buyer of the options hopes to make a profit from the price move of the underlying stock. The buyer of a Call anticipates the stock moving higher and the buyer of the Put anticipates the price of the stock to drop. The buyer of the option has the right, but not the obligation to "exercise" the option.
The seller of the Option collects the premium which is the maximum profit potential but has the obligation of the Option. The seller of a Put is obligated to buy the underlying stock at the agreed upon price (strike price) should the buyer exercise the Option. The seller of the Call has the obligation to sell the stock if the buyer exercises.
The determination of being exercised is based upon the price of the stock compared to the strike price. In my example we sold a $9.00 Call. In other words we agreed to sell our stock at $9.00. If the price of the stock, at expiration is above $9.00 we would be exercised. However, if the price is below $9.00 no one would want to buy at our stock at $9.00 if it is trading at $8.75 and they could buy it at market for that price. In that case the Option would expire worthless.
It seems difficult at first, but it is really pretty simple. Hope the explanation helps
The Option has a specified date of expiration, which will be the third Friday of the month of expiration.
psychicdog.net on March 05, 2010:
fascinating! Though hard to understand for me what a call option actually is.