HOW TO WRITE COVERED CALLS - A REAL CASE STUDY!
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PAGE #4 Date: Saturday, Feb. 08, 1997
The stock: ROSS STORES (ROST) Last traded at $44.00 up 1/2 on Fridays' close. 2 for 1 split - Record date Feb. 11, 1997! Will increase dividend also!
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REVIEW OF THE DATA - I ASKED MYSELF THESE QUESTIONS!
C. WHAT COVERED CALL STRATEGIES WILL I EMPLOY?
D. HOW WILL I PAY FOR IT?
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C. WHAT COVERED CALL STRATEGIES WILL I EMPLOY?
I will buy three contracts of ROSS (OPT SYMBOL)MARCH 45 CALLS for around 2 1/2 ($250) to 2 3/4 ($275)each contract. That's $ 275 x 3 contracts = $ 825.00 plus ($45.50)commissions. Of course, I'm going to use somebody else's money. In other words, the person I collected the call premiums from over the past three weeks. I think I can spare $885.50 or so out of the $2,500 I've collected so far over the past two weeks.
Hey, somebody got to do it! It's what keeps the stock liquidity flowing you know! It would be un-American to not help fuel the economic system. How about that open interest for the ROSS March 45 calls? It is more than any other month or strike price at 318 contracts. Well, I won't have to worry about being alone! I guess I'm not the only astute options investor around? Looks like alot of people are expecting some up side price action, right?
I plan to buy the calls, wait for notice of 2-1 split option value recorded, exercise the option to buy at $45/share pre-split or $22 1/2 after-split, 600 shares of ROST (ROSS) for $13,500 dollars which I'm going to buy with 50% margin of course!
Once I take possession of the 600 shares I will wait a day or two for the price of ROST (ROSS) to increase above the $22 1/2 purchase price and my net cost basis (YOUR NUT), then write (limit sell) six call contracts. I need to have a net cost basis lower than the selling price of the stock in order to start the money machine's main engines! I can not determine that price at this time nor the demand for the calls. But, we can review the math:
CALCULATE YOUR NET COST BASIS:
3 (2-1 split) March 22 1/2 contracts will cost me $885.50 + $13,500 ($6,750 margin) for the stock purchase = $14,385.50/600 shares equals a net cost basis of $23.98 per share to start. Note, this is THE NUT THAT I MUST NEVER LOSE TRACK OF DURING ALL MY COVERED CALL WRITING! This is the gas gauge! The premium for the first 6 contracts (for the 600 shares) in our case study will need to generate enough to reduce further our net cost basis. So, with a $23.98 cost we need at least the following:
ASSUMPTIONS: THE STOCK PRICE MOVES TO ONLY $46.00/SHARE ON THE RECORD DATE FEB.11,1997 and remain there until the stock actually splits. The adjusted split price should start at $23.00 per share. With a dividend increase and payment following the split and an upcoming earnings report. I would be SHOCKED IF THE STOCK DOES NOT TAKE OFF and move up to $26.00 in the first week! That's only a 13% increase. It should not be that hard for a $20 dollar price range stock with good earnings.
Therefore, our number should look like this:
Stock price ....................$ 26.00 - $15,600 value
THE NUT (net cost) ......$ 23.98 - $14,388 cost
.........................................------- - --------
...................................$ 2.02 $ 1,212 Profit
................ (8.42% straight, 16.85% margined) Week #1
TWO POSSIBLE CONSIDERATIONS:
MR. NICEGUY! Strategy A: No doubt the price will increase because of the dividend and expected earnings report. We can sell (write) 6 covered calls at the 25 Strike price one month out for approx. 1 1/2 to 1 5/8. Let's go with the lower number for this rough calculation now. We will have more to say when we actually get close to the split. That would produce $150 x 6 = $900.00 in premiums not counting the commissions which is peanuts!
DING DONG! DID YOU HEAR THAT CASH REGISTER SING? "HAVE SOME NEW INCOME - PLEASE RECALCULATE YOUR NUT!" $14,388 - $900 = 13,488.00 or $22.48/share
Stock price....................$ 26.00 - $15,600 value
THE NUT (net cost)...... $ 22.48 - $13,488 new cost
....................................... ------- - --------
....................................$ 3.52 - $ 2,112
............Profit (15.6% straight, 31.32% margined) Week #2
Now, if you are called out you would be paid $25 x 600 = $15,000. I HAVE NEVER BEEN CALLED OUT OF ALL MY SHARES! NEVER! Eighty percent of the time call options are NEVER EXERCISED! So, you keep the money and you still own the stock!
Don't believe me and you are a worry wart! Relax! You just pulled in some dude's hard cash right? AHHHHH yes! The $900 HUNDRED DOLLARS! Why not buy some ROST (ROSS) calls yourself? If you are so sure the price of the stock is going up to the moon, then just buy the call options yourself and let them appreciate. I bet the call will go up faster than the stock price value anyway! So, you still make money buying the calls and cashing them in pocketing the money. And then, you will be shocked when the person does not exercise the calls anyway! So, you will have all this money being shoved down your throat and the greed will start to work it's way into your eyes! Mannnnnn, that was one heck of a score! Wait till you see strategy B below!
PURPLE HAZE! Strategy B: I named it as such because it won't take you long to realize that it is the call writers that make all the money in covered call writing. I named it after Jimi Hendrix's Purple Haze song. "Purple Haze is in my brain. Don't know if I'm here to stay, acting funny, but I don't know why. Excuse me, while I kiss the sky!" Well, like Jimi you will see a haze. But, the color will be bright green like as in the color of money!
Covered call writing is the closest thing I know that compares to being the black jack dealer in a casino. And yes, you are the dealer with even more control because YOU GET TO PICK THE CARDS BEFORE YOU COLLECT SOMEONE'S CHIPS TO PLACE THE BETS! The most important part you must DRUM INTO YOUR HEAD IS TO MAINTAIN AN ACCURATE CALCULATED NET COST BASIS FOR EACH OF YOUR STOCKS (CONTRACTS). If you do that, even when you are called out you will ALWAYS MAKE MONEY. Only, perhaps not as much!
This approach will work exceptionally well if you are very accurate in your record keeping. You are going out more on the edge! It works like this. The more you write a call into the money, the more you will make in premiums. It's that simple, if you just leave the money in your account and not reinvest or leverage it somewhere else in your portfolio, then you are missing out in opportunities for compound growth in your portfolio. More cash in your account means more value and more value means more margin. I have a great deal of confidence in my abilities with all the practice I've had! So, I'm not alarmed to be 60% on margin since all my positions HAVE MUCH LOWER NET COST BASIS THAN THE CURRENT PRICE OF THE STOCK! That is, I can alway sell the stock and still walk away with a clean profit. Under those conditions! Margin interest cost and comissions don't impact me as much as once did. I will teach you at a later date.
I use my charts to determine when the stock price will meet some upward resistance. Usually, a new high will sooner or later reach a point of resistance. The price will drop fast because of profit taking. The options will erode EVEN FASTER! There are three factors that make up the value of a call and put options: 1. price (value) 2. time (months out) and 3. Volatility (risk).
It is that third element that you must not fear when writing covered calls. In fact, it can be your best partner. It's like you looking at your DOPPLER RADAR screen and seeing some nasty thunder storms ahead and someone want to rent your mopeds! Of course, you have collected a deposit (nice call premiums) and you have a NO MONEY BACK POLICY! Now, you would not go out for a ride on such a day, would you? But, there are always others (call buyers) that will! Why, because they looked out their window (the stock market) or door (a stock tip from a friend) of their home and appeared to be cloudy, but, basically a good day! Back to the play!
At the high point of the price rise (say $32.00) we can sell (write) 6 covered calls at the $25 Strike price two months out for approx. 7 to 7 5/8 points. Rough calculation now. That would produce $700 x 6 = $4,200.00 in premiums not counting the commissions which is smaller than dust in this example!
DING DONG! DID YOU HEAR THAT CASH REGISTER SING? "HAVE SOME NEW INCOME - PLEASE RECALCULATE YOUR NUT!" $14,388 - $4,200 = 10,188.00 or $16.98/share
Our number should look like this:
Stock price...................$ 32.00 - $19,200 value
THE NUT (net cost).....$ 16.98 - $10,188 new cost
........................................ ------- - --------
....................................$ 15.02 $ 9,012 Profit
.......................... (88.45% straight, 176.91% margined)
If you are called out then $25 x 600 share = $15,000
........................................ your new cost... $10,188
..................................................................... ----------
................................................................... $ 4,812
profit (47.23% straight, 94.46% margined)
Now, I know what you are going to say about these two outcomes! Hey Herm, we lost money if we get called out! Well, maybe, and maybe not! Here is were most people get scared and start to doubt themselves!
a. The price is at a high point after the split. The odds are in my favor that GREED WILL DRIVE the stock price down AFTER I SELL MY DEEP IN THE MONEY CALL! Further, When it does start to go down I will be watching the sucker go down, down, down, and the call I sold to the buyer will drop like a rock! Sure, my stock value goes down! But, ahhhhhh, I have that dudes money in my account to make me feel better! The fact is that the buyer of my call will lose most of his/her money! Now, I can cover at bargain prices say 4 points or $400 and sell the calls to someone else again! Thus, I can make more money and RECOVER THE LOST VALUE! I will call this defensive move DIPPITY DO'S. That means when the stock price drops, you look to cover your calls and write another. You can sell calls out two months and combine the two premiums to equal more than the price drop in the stock! IT'S A MATHEMATICAL SURE THING! I DO THIS OVER AND OVER AGAIN AND HAVE NEVER LOST OUT! We will practice that with our ROST (ROSS) case study AS IT HAPPENS!
b. If the price takes off even more I simply have to use of the dudes money ($4,200 in my account) to buy more ROST (ROSS) calls just in case the price does go against me.
FACT! If someone paid me 7 points for a stock at the $32.00 price, his break even nut would be $32.00 + 7 = $39.00 and then commissions. I'm smarter than that folks! Human greed and fear will spook that stock as soon as the price reaches the previous high.
REVIEW OF RULES: You should try to anticipate the direction of your stock. If it's going up fast, you may want to raise your strike prices one or two calls above YOUR ADJUSTED NUT (net cost value). If you sold covered calls and the stock price starts to drop, ALWAYS LOOK TO COVER YOUR CALLS (if at least 75% of the call value is gone) AND REWRITE SOME MORE CALLS ONE OR TWO MONTH OUT AND WITH LOWER STRIKE PRICES. MAKE YOUR BUYER PAY FOR YOUR DECAY! I never have a problem finding some dude to take my give back (temporary lost) off my hands (in other words dropping stock prices). I just can't believe how nice call buyers are! They pay me all this money to watch their money go up down, sideways and finally my way!
ALLWAYS KNOW YOUR NET COST BASIS even when you are calculating WHAT IF strategies! Look for my Excel spreadsheet with my easy calc no brainer money machine! Coming real soon folks!
D. HOW WILL I PAY FOR IT?
For me, one word not Rolaids, but MARGIN!
An investor needs around $2,000 in cash or in stock value in order to be considered for a stock margin account. Stock margin is a loan of credit at a very low interest rate! It can really enhance your rate of returns. Typically, I pay around $100 for margin interest and make around $ 2,500 profit during that same time I'm being charged for the margin. It does not take a poke in the eye with a sharp stick to realize that $2,500 dollars vs. $100 is a pretty good deal for me! If I did not use margin my economy of scale would be cut in half! Thus, my money machine cranking out $2,500+ in profits would be reduced to at least half ($1,250) and maybe even lower. IF YOU ARE IN CONTROL OF YOUR EMOTIONS - AND YOU HAVE PRACTICED DOING COVERED CALL WRITING, THEN I WOULD SAY START OFF WITH TWENTY FIVE PERCENT MARGIN. That is, you would pay for 75% of your stock in cash and the other 25% would be spotted by your broker. I tend to use 50% to 60%. The extra cushion allows for stock prices that can and do drop from time to time. If you are producting a monthly cash money stream, you should not notice more than a 2% to 4% fluctuations in the ratio equity vs. liabilities (margin) during period of market volatilities. I call it the DIPPY DO's TIMES! REMEMBER, a dip in prices means you look to cover and rewrite your covered calls.
Another way to look at it! If you are short shares for an even lot of 100 shares, then buy the rest on margin and start writing those covered calls. You can only write covered call with even lots of 100 shares of stock! So, if you paid for 230 shares of Purple Haze Company, and you are missing 70 shares to make an even 300 shares. GO FOR THE MARGIN! Try not to write anything less than 3 covered call contracts. The commissions will eat up a great deal of your percentage rate of return.
I will be getting more into margin and portforlio cash management in the weeks to come as I comment on ROST movements and my actions! YOU WILL BE LOOKING OVER MY SHOULDERS AND SEEING FIRST HAND HOW IT WORKS!
END OF PAGE #4 CONTINUE TO PAGE #5
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DISCLAIMER: The writer is presenting a real stock and a live ongoing case study. No recommendations or endorsement to actually buy this stock are suggested nor implied. Trading stocks and buying calls should not be attempted without first understanding the risk/rewards of this type of investment!
The writer assumes no responsibility for the opinions being expressed!
Buyers always be aware!
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