[Mick]

Here is the first "Lesson" I wrote for interested folks. I probably wrote it almost a decade ago, but I gave it a quick read, and it looks just as applicable today:

Trading Options Lesson #1: Selling a Covered Call

First, this will be long so here are your Cliff’s: Don’t read this if you are not interested.

It came up in another thread that some folks on here are relatively inexperienced investors, and are interested in options. I put this together to try to explain a basic option transaction, hopefully without any jargon, and in 1200 words or less. Because the topic of “selling covered calls” came up, and happens to be an excellent place for a beginner to start, I have addressed this transaction below. The following is my view, and my opinion, developed from 20 years of experience trading options. It is not intended to be investment advice. What is written is intended to be solely about options on commonly traded equities.

I’ve written it in five sections as follows:

1. What is a call option?

2. What does buying and selling a call mean?

3. What is a covered call?

4. The story of my first covered call.

5. The pros and cons of selling a covered call.

1. What is a call option?

A call option provides the buyer of the option the right, but not the obligation, to buy 100 shares of a pre-specified stock (the “underlying equity” or often just “the underlying”), at a pre-specified price (the “strike price”), on or before a pre-specified date (the “expiration date”).

2. What does buying and selling a call mean?
When someone “buys” the call, they buy the right, but not the obligation, to buy the underlying stock as specified above, at the strike price on or before the expiration date. As with most things in the economy, for every buyer, there is a seller. The person who sells the call, is selling the buyer the right to buy the underlying stock from the seller of the call, at the strike price on or before the expiration date. When the transaction is made, the buyer pays the seller an agreed upon price (called the “premium”) to get that option from the seller. For clarity: once the buyer buys the option, the seller of the option is obligated to sell his stock to the buyer of the option at the strike price if said buyer chooses to exercise his option. Another term for selling an option is “writing” an option, so “selling a call” and “writing a call” mean the same thing.

3. What is a Covered Call?

If the seller of the call already holds the 100 shares of the underlying equity in their account, the call is said to be “covered” by those shares. Meaning, if the buyer of the call wants to exercise his call the next day, the shares are already in the sellers account so that he can just buy them directly. If the seller does not hold the shares, the call is said to be “uncovered” or “naked”. Selling naked calls is much more risky than selling covered calls, so I will not address that here.

4. The story of my first covered call:

For well over a decade, I had been buying options but had never sold one. Probably for the same reason as lots of folks, I wasn’t sure I really knew what I was doing, so I was a little afraid of getting in over my head. About 5 years ago, I bought 100 shares of Apple (AAPL) for $180 per share. I loved the stock, but it was very volatile. I noticed that because of the high volatility, the option prices were sky high, so I was talking to one of my advisors about the possibility of writing a call on my new purchase. We looked at it a bunch of different ways, but the one we thought had some real validity was this:

Since I just bought the stock, if the price ran up really fast, would there be a point where I figured I had made my money, and sell to take the profit? Of course, the answer was yes. I was sure that if the stock ran up $20 in the next month or so, I would sell and take the profit. Based on that, and the fact that I am a reasonably disciplined investor, the question changed from “Why sell the call?” to “Why not sell the call?” 200 strike options a month and a half or so out were trading at $8 per share, so I could get $800 minus a commission for the call, so I sold it.

5. The Pros and Cons of Selling a Covered Call:

Let’s start with the cons, because the pros are easy and people seem to see a lot of cons. The first thing people often say is: “you will lose money if the stock runs up past the strike price”. Well, I would say I won’t “lose” money, because it was money I never had in the first place. I would also say that if I am a disciplined investor, and really did sell when the price hit $200, I wouldn’t “lose” any upside, since I would be out of the stock with or without the sale of the call.

The next thing they say is “your brokerage firm won’t let you sell the shares when you have them covered, so if the shares start dropping, you won’t be able to get out and will therefore lose more money than you would without the call.” This starts out right, brokerage houses will only let the most experienced options traders have naked call positions, so the regular Joe can’t sell the shares with the call out on them. However, when the stock drops, so does the option price. So if I want to take my lumps in the underlying, all I have to do is buy back my call and I can go ahead and sell my shares. It is likely (though not guaranteed), that I will net a small gain on my call, which will offset some of my loss on the underlying. I would not have had access to this small gain had I not sold the call in the first place.

Now, to the pros: There is really only one, but it is a nice one, the premium. Once I took that $800 premium, it’s mine. No matter what happens, I don’t have to give it back. I may choose to give some of it back if I want to get out of a falling stock, but I don’t have to. In the investing world, cash I can stick in my pocket with no obligation attached is a sweet thing. Oh, and I might have to give up my shares, but I’ll get paid a nice profit on those too. I love it when my stocks get called away, because that means I made money on the stock, AND have a premium in my pocket.