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Increasing Income with Covered Writing Ideas

Covered Writing is an options strategy that we discuss on a regular basis, as it is one that could help accomplish clients' needs.  For instance, covered writing can generate income, offset downside risk, and is applicable in many market environments. Let's first review the general concept and objectives for covered writing.

A covered write (or covered call) is simply a position that is bound by a long position in a security and a short position in a call option tied to that security. By design any "covered write" strategy is in fact a bullish strategy, but it can be applied in such a manner as to cover just about every shade of color along the bullish spectrum. The math essentially comes down to a term with which most any option trader is well familiar; delta. When you are long stock you are long shares with a delta of 1.0, which simply means that for every 1 point move in the stock, your position is in turn expected to move 1 point. The math is straight-forward there, and is not even unduly complicated when you add the option position into the equation. When you sell a call option you are essentially selling part of the delta you established when buying stock. The delta for a call option may be 0.25, which means for a 1 point move in the stock that option is expected to move 0.25 points. In terms of a covered write with those parameters (long 1 delta, short 0.25 delta), you are effectively long 0.75 delta. Again, the math is not overly complicated.

While covered writing can be applied in ways that are conservative, it is generally considered a bullish strategy because the highest return will come when the stock is above the strike price and is called away at expiration (or before). That does not mean the stock can’t go higher. It most definitely can, but in a covered write position the call (or calls) sold against our stock will place a ceiling on our profit potential. We know this going into a covered write and should surely not be surprised by the result after the fact. So, the long and short of the covered write is that we are stockholders first and that we want the stock to rally and hopefully get called away. If we are called and sell our stock, we get the appreciation of the stock from its purchase price to the strike price, plus the premium received from selling the call, plus all dividends paid on the stock up to that point. It is in this manner that the covered write can be employed as a strategy with upside potential, some downside protection, and a stream of income from writing the calls.

We use the DWA system’s Covered Call Calculator.This calculator helps give us a way to see if a covered write could be worthwhile. When we recommend covered writes, we do not select the best covered writes, those with the best returns. This typically places us in the most volatile stocks. While the returns on paper may be high, it does not necessarily follow that their probabilities of being called away are high and we are more interested in that. Consequently, we first look at the technical stance on the stock to see if demand is in control. If not, then we walk away from that stock.

If it looks okay technically and demand is winning the battle, we then look to see if the returns justify initiating the position. Generally speaking, we want a 20% annualized called return, 10% annualized static return and at least 4% downside protection.

Investment:

The calculator measures the investment by taking the stock investment plus commission and  then subtracting the net option premium (option premium plus commission).

Static Return:

The static return is calculated by assuming the stock remains right where it is and the call is not exercised. If that happens, our gain is the option premium plus any dividends received minus the commissions. This is divided by the investment to get a return for the period. This is then divided by the days to expiration and multiplied by 365 to get an annualized return.

Called Return:

The called return is along the same lines. It is the funds received from the sale of the stock minus the commission plus any dividends minus the investment. This is then divided by the investment to receive the called return for the period. Once that is done, you divide by the number of days until expiration and then multiply by 365 to get an annualized called return.

Downside Protection:

The downside protection is calculated by subtracting the option premium from the investment and then dividing by the number of shares purchased. This will give you a breakeven price. This in essence is where you would break even at expiration. You subtract this breakeven price from the purchase price, and then divide by the purchase price to arrive at the percent of downside protection.