Boosting Your Income with Options
Pages: 1, 2
Making the Most of Your Covered Call Writing
Buying your underlying stocks at the lowest possible price and then selling your call options for the highest possible premium generates the best results. Technical analysis can help you spot advantageous times to buy the underlying stocks. To sell covered call options for more attractive premiums, you must understand the factors that affect the pricing of call option premiums.
Technical analysis uses historical stock prices and trading volume to anticipate where a stock's price might head in the near future. Although you can call upon as many technical indicators as you want, two are particularly helpful for choosing when to buy your underlying stock: support levels and Bollinger bands.
As described in Hack 52, "Support and Resistance," in Online Investing Hacks, a support level is a price at which traders or investors are willing to buy the stock, which restrains the stock from dropping lower. Figure 2 shows a price chart for Jack Henry, a financial services company. Over the past six months the stock price has dropped to $18 and a bit lower several times, but it pops back up quickly each time. The $18 price is a strong level of support for Jack Henry's stock. As long as nothing has changed with Jack Henry's fundamental performance, you might decide to buy Jack Henry shares when the price dips below $18. Furthermore, when a buyer exercises a call option and purchases your shares, you don't have to replace your shares of stock immediately. You can wait until the price drops to the support level again to replenish your inventory.
Figure 2. You can choose a good buy price by studying support level and Bollinger bands on this price
chart for Jack Henry.
The price chart in Figure 2 shows Bollinger bands--an indicator of the volatility of a stock's price--as solid blue lines. Bollinger bands represent the moving average of the stock price plus two standard deviations. Quite often, the stock price increases after it bounces off the bottom Bollinger band, as it did in February, March, and May. In each instance, the stock price bounced off the bottom Bollinger band at about the same time it dipped below the $18 support level. To simplify your stock purchases, you can set up price alerts (Hack 24, "Create Alerts") to notify you when stocks drop below their levels of support.
To maximize your income from option premiums, you can wait for option pricing factors to work to your advantage. Although new options become available each month, you can wait until the option premiums are attractive. Option premiums depend on the following factors:
Underlying stock price--The option premium increases as the stock price reaches or exceeds the option strike price. Selling a call option when the stock price is above the strike price doesn't guarantee that the option will be exercised. Options are typically assigned only when the stock price exceeds the strike price just before the option expires. Waiting for the stock price to near the strike price fattens the option premiums that you collect.
Option strike price--Options are available at a variety of price levels, and the difference between the strike price and the stock price affects the premium. For example, a stock that sells at $20 might have options with strike prices at $15, $17.50, $20, and $22.50. When the strike price is below the current stock price, the option premium includes what is known as intrinsic value. The option buyer can exercise the option, buy the shares at the strike price, and immediately profit by selling the shares at the higher market price. That immediate profit per share shows up as the intrinsic value of the option premium. Of course, if you want to try to hold onto your shares, you sell in-the-money call options--call options whose strike price is above the current stock price. For those options, the one with the strike price closest to the current price offers the highest premium.
Volatility of the stock--Volatility is the amount that a stock's price jumps around. Higher volatility increases option premiums for two reasons. First, option buyers are willing to pay more for the options because they stand to make more money from them. Second, option sellers want more premium for the options they sell because the transaction is riskier for them. As mentioned before, Bollinger bands represent the volatility of a stock. By selling your call options when the stock price approaches the top Bollinger band, you take advantage of increased volatility and stock price closer to the strike price, both of which boost the option premium.
Time until option expiration--Options have a defined lifetime, and the value of an option decreases as its life nears its end. The time value of an option is highest on the first day of an option cycle (the fourth Monday of each month). From a seller's perspective, you want to sell your call options as early in the option's lifetime as you can. However, the option premium is a combination of the time value and the intrinsic value, so you might wait for the stock price to get closer to the strike price.
Dividend paid during the option's lifetime--When dividends are distributed, they reduce the price of a share of stock. Therefore, dividends that will be paid during an option's lifetime reduce the premium for the stock's call options.
Current interest rate--Option premiums also depend on the interest rate for a theoretically risk-free investment (such as a treasury bill). As interest rates increase, so do call options' premiums. However, this factor typically won't affect your timing for a call option in a given month.
The bottom line for deciding whether to sell a call option on a stock and when: the stock price is approaching or exceeding the option strike price within the first two weeks of the option's duration. For example, if LEML has a volatility of 70 percent, the call option premium on the first day for the call option might be $.75. However, two weeks into the cycle, the option premium would drop to $.37 for the same underlying stock price.
For covered call options, the underlying stocks are much like a store's inventory. You replenish your stock after a sale. If you also invest in stocks for growth, you typically want to hold onto those stocks for the long term. Buying and selling long-term holdings makes it difficult to keep track of your overall return for those stocks, so you should consider keeping your covered call stocks in an account separate from your growth investments.
Keep Costs Down
Expenses such as broker's commissions chew up income, so it pays to hold your costs down as much as possible. Use a deep-discount broker such as ScotTrade or Brown and Company with commissions in the $7 range. Although limit orders often cost a bit more, consider selling your call options using a limit order with the premium you want to obtain. Because many brokers charge a minimum for an option trade, such as $6 with $1.50 for each option contract, buy 200 or more underlying shares to cover two or more options contracts.
For More Information
If you want to learn more about options or the covered call income strategy, check out the Option Industry Council's web page, or pick up New Insights on Covered Call Writing (Lehman and McMillan, Bloomberg Press, May 2003).
Bonnie Biafore writes about project management, personal finance, and investing. She's the author of Project 2007: The Missing Manual, as well as Online Investing Hacks, QuickBooks 2008: The Missing Manual, and Quicken 2008: The Missing Manual.
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