Covered Call Options – Possible Outcomes?

by Wes Bridel on May 25, 2011

in Stewardship

Covered Call Options reduce your portfolio risk while paying you immediate income.  We began discussing call options here.  Today, we’ll look at the possible outcomes you could face as a covered call option seller.  First, let’s display an example of options available…

Calls for Feb 19 201

Last Change Bid Ask Volume Open Int Strike

0.23        -0.03        0.24 0.25 133                7,381             23

0.11          0.00        0.10 0.11 32                 9,148             24

(The above information is educational in nature only.  The information is not current and can not be bought or sold today.)

So today you bought 100 shares of Intel which currently trade at $21.47.  You could sell 1 $23 Strike Price Option and receive about $24.  This is about 1.12% extra income on top of the 2.9% Dividend that Intel already pays you annually.  If your stock was never called away from you and you repeated this exact sale of this covered call for an entire year, you would receive 6.7% over the course of the year.  By adding this Covered Call income to Intel’s Dividend, you receive a total of 9.6% over the course of the year to hold a stock which you had already decided you loved to hold.  (Remember that the income you will be paid each two months will vary so this is a theoretical exercise and would not happen exactly like this in real life.)

The downside is that if Intel begins selling a chip to every man woman and child in India and China and the stock goes through the roof while you are under a sold call option contract, you would lose the upside of the Intel stock above $23.

Let’s look at the possible scenarios…

1)      The Covered Call Option expires worthless.  This happens if the current market price is below the strike price ($23) for Intel on the expiration date (Feb 19th).  This is fantastic because you were paid income up front and now that the time of the option is over, you are no longer obligated to anything.  You can forget all about the option and continue to hold the stock by itself (or sell it if you want to), or you can repeat and sell another covered call option.

2)      The Covered Call Option is exercised.  In this case, you were paid money up front and then you were obligated to sell the stock at the agreed upon price ($23) on the expiration date (Feb 19th).  This is profitable news because you bought Intel at $21.47.  You were paid 1.12% ($24) to sell the Call Option and then were forced to sell Intel at $23 which is 7.1% above what you had bought it for. Add up your call option income and your capital gain on your Intel stock and you have earned a total of 8.22% over a period of about 2 months.

If you are able to repeat this option trade for a full year before your Intel stock is finally “called away”, you would have 6.72% in option income plus the 7.1% capital gain on the sale of your stock, plus the 2.9% dividend and you have a total annual gain of 16.72%!  Not bad in a world of zero percent interest rates.  Again, this is theoretical, your stock could be called away during any of these months and it’s impossible to say at which point it would happen.  The point is that you are increasing your guaranteed income by being willing to trade away some of the potential explosive upside.

This is Post 10 of a new series on stock options which we’ll be revisiting every few days.  You can find the first few parts at the following links: Pt 1, Pt 2, Pt 3, Pt 4, Pt 5, Pt 6, Pt 7, Pt 8, & Pt 9.

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