How to Energize Your Stock Portfolio

For establishing a strategy that tempers potential losses in a bear market, the investment community preaches the same thing that the real estate market preaches for buying a house: "location, location, location".

Everyone is looking for an edge to either boost or protect their portfolios, and stock investors are no different. In this section, we discuss a technique called covered-call writing that involves selling a call option on stock that you own. A call is an option that gives the buyer the right, but not the obligation, to purchase a fixed quantity (usually 100 shares) of an equity at a fixed price (the strike price), on or before a specified date (the expiration date). The call seller or writer, on the other hand, incurs the obligation to sell 100 shares of the underlying stock at the strike price at any time the call buyer wishes to exercise their rights prior to the expiration date.

Those unfamiliar with the world of options are often quick to dismiss all options trading strategies as too risky, too aggressive, or simply too rich for their blood. What these skeptics don't often recognize is that some option strategies can be used in a conservative way to protect against short-term declines in the market. By hedging an existing stock position with options, it is often far easier to weather the downside in one's portfolio. Such is the case with covered calls.

What is a Covered Call?
Covered call writing is a popular strategy for those looking to hedge their stock positions over the short term. Many investors also use covered calls to generate cash when they envision a stock that they own stagnating over the short term. At the same time, they feel there is little downside risk in the near future.

Simply stated, covered-call writing involves selling one call option for every 100 shares of stock that you own. The writer of the call options receives income from the buyer in the form of the option's premium. In exchange for the premium received, the seller of the call takes on the obligation to deliver the shares to the call buyer at the strike price in the event the shares are called away from the call seller.

Covered calls accomplish two purposes. The desire to lower one's risk is generally the primary objective of the covered-call strategy. In effect, selling a covered call reduces the ultimate cost of maintaining an equity in one's portfolio. In other words, the downside risk of owning the underlying stock can be reduced since the premium received from the call side acts as a cushion for the underlying stock's downside movement. For example, selling a 100-strike call for $10 on a stock trading at 100 reduces the stock's effective cost by 10 points to 90, and thus reduces the negative impact of a decline in the share price.

The second objective is to efficiently capture an option's time premium, i.e., the price of an option less its intrinsic value. (Intrinsic value for a call option is the amount by which the current stock price exceeds the call's strike price). An at-the-money or out-of-the-money option consists entirely of time premium. Thus, the premium received can increase the stock's overall rate of return by providing income on the position. Using the same example as above, let's say the stock advances to 110. Without selling the call, the return would be 10 percent: 110/100. With the added income from the written call, the return jumps to 20 percent: (10 + 110)/100.

Covered-Call Considerations
There are a number of reasons an investor may choose to sell covered calls. The successful covered writer chooses a specific call to sell based on his expectations and objectives. The two major factors to consider before writing a covered call are your expectations for the underlying stock and your particular strategy objective.

If you expect the underlying stock to rise, your objective may be an above-average return - a combination of premium income and any appreciation of the stock price up to the strike price. Thus, if the call is exercised, you have met your objective. (Keep in mind that selling a call limits the upside on your stock position to the strike price of the call. As the stock price rises above the strike price, the gain in the stock position is offset by the obligation incurred from the sold call.)

If you expect the stock to remain stable, your objective may be to generate cash flow or produce income on a dormant position.

If you expect the stock to decline moderately but are unwilling to sell out the stock position at its current value, your objective may be to offset some of the loss on the stock.

In order to decide which call to write (sell), you must have a clear understanding of the relationship between the current market price of the underlying stock and the exercise price of each call and how that will affect your strategy. This relationship is defined in three ways:

1. Out of the Money

   A call option is out of the money when its strike price is higher than the price of the stock. You receive the smallest premium for an out-of-the-money call and therefore get the least downside protection with this type of call.

   However, the out-of-the-money call provides capital appreciation potential up to the strike price, in addition to the income received from the sale of the option. Therefore, when you sell an out-of-the-money call, you establish a selling price for your stock above the current market price and the option premium received increases the total return.

   XYZ = 55
   60 call = out of the money (stock price below strike price)
   5 points of capital appreciation available (60 - 55)

   This type of call is well suited to the trader who wants to participate in a moderate rise in the price of the stock before he is willing to let it go, but at the same time wants a little protection in the event of a short-term decline. In effect, the trader is putting a limit order to sell the stock at the call's strike price and is receiving income (the option's premium) to do so.

2. At the Money

   The strike price of the call is at or near the price of the stock. Because the stock is trading at or very close to the strike price, you will receive a higher premium than the out-of-the-money call option and a little more downside protection. However, in the event of a rally, you will not be able to participate in any of the appreciation of the stock.

   XYZ = 55 55 call = at the money (stock price equal to strike price)
   no capital appreciation available

3. In the Money

   The strike price of the call is lower than the stock price. Because the stock price is above the call's strike price, you receive the largest premium for an in-the-money call and the greatest amount of downside protection. Those that write in-the-money calls against stock positions have a strong conviction that the shares will move significantly lower over the short term.

   A higher probability of the stock getting called away is a very important consideration in planning a covered writing strategy. When an option is in the money, the greater the chance of an exercise. Thus, you incur the greatest likelihood of having your stock called away when you sell an in-the-money call.

   XYZ = 55 50 call = in the money (stock price above strike price)
   no capital appreciation available; stock likely to be called away

Profit/Loss Implications
The chart below compares the profit/loss lines of a straight stock purchase versus a covered call. In this example, the stock is at 50 and a 55 call (out of the money) is sold for 1.50, or $150 per contract.