Sunday, October 24, 2010

Helen asks; what is a covered call?

Options are difficult. Unless you are studying to pass the series 7 securities license, do not bother to learn all the permutations of options.  If you are interested in creating additional capital gain income from owning stock in a company, then you should learn about covered calls.
An example may be the best way to start.
If you own 100 shares of a company let us use Caterpillar symbol CAT and you bought it today at $65.50 you will own a company that pays $1.70 per share this year in dividends alone.  In addition, you should be aware that the dividend has consistently increased over time. So your stock is one that meets all of TheMoneyMadam’s four criteria for buying a stock.

To increase your income from CAT, you can sell a call to another person which gives them the right to buy your CAT stock. This is a covered call.  Yes, someone will pay you money for the right to buy your stock at more than you paid for it.  
Today I bought CAT for $65.50.  I sold a covered call for $1.57 per share.  Someone paid me $1.57 for the right to buy my CAT stock for $72.50 between now and November 20, 2010.  I hope they do.  I get $1.57 per share from the covered call.  I get $.44 a share in the dividend to be paid in August, and I get $7.00 per share of profit (the difference between what I paid for CAT $65.50 and what the buyer of my stock will pay me $72.50.)  In 4 months, I will have made 13.8%.  

A covered call is an option contract and it means that the other person will pay you in this case about $1.50 per share so that is $150 for 100 shares for the option to buy  CAT at $72.50 before the end of November. They pay you right away.  However, they are not obligated to buy the shares so you could end up owning the stock if it is at or less than $72.50 in November. 
You, the seller of the call, are obligated to sell your shares at $72.50 if the buyer wants them.  Of course, the buyer will not buy your shares unless the stock is greater than $72.50.  Who cares? You will receive the $1.50per share plus any dividend that is paid between now and November and you get the gain between buying the stock at 65.50 and selling it at 72.50.  If you are stuck with CAT, you get a great company with a good dividend and little debt for that kind of company.
Helen, do you understand it?
Yours Truly, TheMoneyMadam