Option Strategy #2 - Covered Call or the Naked Put

The Covered Call, as I mentioned before, is a strategy that I can use in an RRSP account as I own the underlying stock then sell a call using the existing position as the base. I consider this a longer term trade with cashflow in mind rather than a straight trade for quick profits.

I can either already have the stock positing or buy it for the purpose of selling the call, it amounts to the same thing with one difference. Holding a long term position can net some dividends and I can sell calls against it many times to increase the real yield of the stock.

Let's assume that I own BAC stock. I just sold my last stock position Friday so I don't' have anything to actually do this with this week but I may look for one that I am familiar with to try it out, BAC is not actually on the list..

BTW, this has nothing to do with testing any services. Any options trades that are "recommended" are typically straight option buying or some sort of spread, I don't trade the spreads though.

BAC is trading around the $17.50 mark (US dollars here, for tax purposes I could only do this in an RRSP account as the dividends would be subject to a 15% with holding fee at the broker for any other account type.). Say I have 500 shares.

BAC currently pays a quarterly dividend of $0.01. That sucks, I wouldn't pick these guys for dividends for sure but let's say that I have the stock and I expect the dividends to go up and I want to keep the stock. So my 500 shares nets $20 per year...about 0.2% yield.

Weighing the odds of the price jumping past $20, I might decide that by this time in October it will not likely do that... so I will sell the October call at the $20 strike for 20 cents which puts $100 into my account.

Three things happen:

1) Stock price stays neutral, I keep the $100 and can sell another call in late October...perhaps for another $100... doing this every month and change creates an additional $1200 per year. That is a 13.7% yield.

2) Stock price drops to $15.00. Technically I have lost $2.50 per share ($1250 if I sold the stock then) and I still keep the $100 which slightly offsets my loss. I might select a stock with a better priced call option and a better dividend but this is a longer term plan, so I might choose to not sell the stock looking for a dividend and more call writing as I am looking at a cashflow rather than a capital gain. I could still be able to sell calls each month for the $100 (perhaps).

3) Stock price jumps over $20 by the expiration in October. The option buyer gets to exercise the option and "call" the position away from me at $20. If it was at $22 I would be selling my stock to them for the $20 strike price for a profit of $2.50 per share ($1250) and keeping the $100. Maximum profit is therefore $1350, but I knew this going in.

3 B) is that I see the price heading for the $20 mark I can buy back the option for about 80 cents ($400) and take the loss in order to keep the stock. This effectively closes the option trade. I can then immediately sell an option for a higher strike price to re-coupe some of that realized loss.

The maximum gain is limited for the trade but creates a cashflow that can increase the yield of an existing position. For the most part it is a no-brainer trade. The maximum loss is the cost of the stock if it should happen to go to zero, unlikely but possible, less any calls sold against it.

The naked put is a little different but amounts to the same thing. While the capital is not tied up in the underlying stock the broker will likely tie it up anyway as insurance against the put being exercised.

Sell 5 put contracts at the $15 strike for $0.17, total cash is $85.

1) & 2) If the price stays neutral or heads up I keep the $85 and there is no stock to be sold so that is the maximum profit.

3) If the price drops below $15 I will be forced to buy the stock from the buyer at the $15 strike price or I can buy the put back near the strike for about $0.75 and take that loss...assuming that the price looks like it might tumble.

Like the worst case above, if the stock should hit zero I would have to buy the stock from the buyer at the $15 creating a substantial loss. Unlike a naked call this is the maximum loss. A naked call loss is theoretically unlimited in the sense that a huge gap up and a run could force me to buy the stock at much higher prices in order to fill the exercised call.

In the final tally I think that I would rather execute spreads rather than covered calls due to the need to actually hold a stock to as cover, except for the fact that spreads are not RRSP eligible trades. I looked at strangles and they are basically a pair of naked calls and puts protected by corresponding puts and calls strategically placed to maximize profits and minimize losses. I'll look at the strangle later but they are limited profit plays with a much higher win rate. This gets me back to the cashflow idea and how it ties in with the US based trading service that I talked about already. Super high win rates can be better than 50/50 wins while trying to minimize losses. Certainly keeps emotions in check that way.

Jeff.