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posted on 06 November 2015

Covered Calls Extra Income On Long-Term Positions

by Russ Allen, Online Trading Academy Instructor

Online Trading Academy Article of the Week

In last week's article I described a way to build a portfolio at discounted prices using put options. The example I used was GLD, the exchange-traded fund that represents 1/10 ounce of gold per share.

Last week GLD's chart looked like this:

covered call

I mentioned that it would be a reasonable opinion that GLD would represent a buy opportunity in case of a pullback into the $110 area. I described a way to acquire GLD even cheaper than that, which would incidentally allow us to gain some cash flow even if GLD never did drop to $110.

Here is what GLD's chart looked like today:

What is a covered call?

GLD has in fact come down into the demand zone that looks as though it may provide support for a bounce into a new uptrend leg. If we were just starting our portfolio today, and not last week, is there an option strategy that we could use to increase our returns here?

Yes, in fact there is. It is one of the most popular option strategies for good reason. Referred to as the covered call, this strategy involves buying the stock and then selling call options on the stock. The call options provide us with cash today for sure; and in most situations an increased rate of return on our investment.

Let's say that coming upon the GLD chart for the first time today we buy one hundred of the GLD shares at the current price of $109.72. We see the supply zone overhead in the $113-114 area. We believe that GLD will eventually move through that level and continue its uptrend, but that could take several weeks. If it were to happen soon, we would be happy to sell out at that price for a quick profit of $300-400. Then, using our new-found strategy of cash-secured puts from last week we could begin to be paid to wait for the stock to pull back again into a good buy point. And so on.

To get started, we notice that the November calls at the 113 strike price can be sold for $.43 per share. They expire in 22 days. If we sell one of these calls we collect $43 today. If GLD is above $113 at the close of business on November 20, then we will be paid $113 per share for our GLD at that time. Our total proceeds, including the $.43 received for the call, amount to $113.43 per share.

Without the covered call our total proceeds if we were to sell at $113 would be $113. Our profit would be that selling price less our cost of $109.72, for a profit of $3.28 in 22 days. Annualized, that represents a 48% annual return.

With the covered call we still collect the $3.28 profit, but we also received the $.43 for the call for a total profit of $3.71. That would raise our hypothetical annualized return from 48% to 56%. Note that these high annualized returns only occur if in fact GLD goes up and hits our target. What if it doesn't?

Well, let's say that GLD sits right where it is for the next 22 days and closes at $109.72 on November 20. With the share holding alone, we would have a break-even situation - no gain or loss. With the covered call position on the other hand, we have a gain of $.43 per share, an annualized rate of return of about 8% on a stock that did absolutely nothing.

Or, what if GLD went down? Presumably we would identify a stop-loss price at which we would liquidate the position for a small loss, whether we had sold the call or not. Whatever that loss might be, we would still be better off by $.43 with the covered call than we would have been without it.

In fact, the only case in which holding the stock alone pays better than holding the covered call is where the stock rises above the strike price (here $113) by more than the $.43 received for the call. In this instance, that has about an 8% chance of happening based on the volatility of GLD. Put another way, if we own GLD and sell the $113 call there is about a 92% chance that that position will do better than owning GLD alone - pretty good odds.

Finally, selling the covered call has allowed us to create some cash flow from our holding of GLD - like writing ourselves a dividend on a stock that does not pay dividends.

I'm sure you can see that there are definite advantages of using the covered call strategy to increase returns in a portfolio. Done right, it is a powerful tool. Contact your local Online Trading Academy center about our ProActive Investor course where you can learn to write covered calls like a pro.

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