Writing Covered Call Options (updated July 5, 2018)

When we hear the words "put and call options", we usually think of highly speculative financial instruments. And, it's true, except for one particular option… the covered call option. If you have several thousand shares of a particular stock, whether it's Oracle or Cisco or any other company, and you're curious about covered call options, you will find this information useful and potentially quite profitable.

A call option is a contract that gives the owner (buyer) of the contract the right, but not the obligation, to buy 100 shares of a stock at a specified price, at any time before the option expiration date, generally the close of trading on the third Friday of the month. A call option contract is written by the owner of the stock, who then sells the contract on an exchange, in order to generate income. It's called a "covered" call option because the writer owns the stock, as opposed to a "naked" call option, if the writer does not own the stock.

For example, suppose I own 1000 shares of Oracle (ORCL) stock. The stock is currently selling for $45.35 a share in July, 2018. Now let's further suppose that I would be happy to sell my 1000 shares for $47 a share, any time in the next three months. I go to the Yahoo! Finance page for Oracle, click the Options tab and pick September 21, 2018 as the option expiration date. The link to that page is HERE.

I see that ORCL Sept. 21, 2018 $47 call options (ORCL180921C00047000) are Bid $0.94, Ask $0.99. I direct my broker to write 10 call option contracts (a single contract is for 100 shares) and offer them for sale at $0.95 cents a share, or $950 for 1000 shares (ten contracts).

When someone buys the contracts, I receive the $950, and my 1000 shares of ORCL stock are now committed until one of two things happens: either the stock price reaches $47 and the buyer exercises the options, buying my 1000 shares for which I receive $47,000, or else the stock price fails to reach $47 by the close of trading on September 21st. In this case the options expire unexercised; I keep the $950 and the shares, and I can write more covered call options on the same shares.

Psychologically, as the writer (seller) of covered call options, I have to be prepared for either eventuality. I have to be indifferent to having 1000 shares of ORCL stock or $47,950. The only risk to me as the writer of covered call options is that the price of the stock may rise far above the exercise price, and I will forfeit the capital gain above the $47 exercise price. For example, if the stock rises in price to $50 before Sept. 21st, the holder of my contracts would pay me $47,000 for my stock, and then could immediately sell it for $50,000, making a nice profit.

Why would someone want to buy covered call options? There are two reasons. First, the buyer believes the stock price will be well above the exercise price before the options expire, so there is the potential for a short-term capital gain. And, second, the buyer wants to use leverage. Through covered call options, a buyer can control the stock for a fraction of the cost of actually owning it. In our example, the buyer has paid $950 to control 1000 shares of ORCL stock. If the options expire unexercised, he loses his $950. If, however, he has bet correctly, and the share price goes to $50, his profit is $2,050 ($3,000 less the $950 cost of the contracts).

Since most options expire unexercised, buyers are obviously playing the percentages. To use a baseball analogy, they are expecting that a few home runs will compensate for a large number of strikeouts.

While this is a real-world example, it isn't completely realistic because I have ignored broker commissions. A broker might charge me $150 to write ten contracts covering 1,000 shares. So to make the transaction cost-effective, I must own enough shares, and write enough contracts, so the broker's commission becomes a relatively minor cost.

Some stockholders actually do want to sell their shares, and they use covered call options like a limit order, equivalent to telling their broker to sell their shares when the price reaches a price equal to the option exercise price.

However, other stockholders use covered call options as a way of generating income, equivalent to a stock dividend. They don't really want to sell their shares, so their goal is to pick an exercise price and exercise date that allows them to generate some income, while having a low probability that the call options will actually be exercised. For these stockholders, their shares are like a "money machine", and the covered call option process is like a "crank" on the machine. They "turn the crank" in order to generate income.

The rule among experienced covered call option writers is: "Buy the stock on dips, and write covered call options on strength." In other words, when the price of the stock is falling, buy the stock. When the price of the stock is rising, sell the covered call options. This rule is particularly effective if you can identify a seasonality pattern in the stock price. For instance, if a company typically has a weak third quarter and a strong fourth quarter, you would buy the stock in the third quarter when weak earnings are projected and the stock is falling, and you would sell the covered call options in the fourth quarter when strong earnings are projected and the stock is rising.

Note that income from selling covered call options is considered ordinary income for federal and state income tax purposes and must be declared on your tax return. At the same time, broker commissions that you pay are considered an expense and are deducted from the income.

Call options that are priced below the current stock price are "in the money" options, while those priced above the current stock price are "out of the money" options. As you might expect, the farther out the exercise date, the more the call option is worth, while the higher the exercise price compared to the current stock price, the less the call option is worth. So it becomes a balancing act. The major considerations are: (a) how strongly do you want to keep (or sell) your shares? and (b) for how long a period do you want to commit your shares?

My personal experience, having repeatedly sold covered call options over a five-year period, was that I was most comfortable with an option exercise date three to four months out and an option exercise price that was close enough to the current stock price to give me a 1%-2% yield ($0.50-$1.00 per share on a $50 stock)

I hope this information has been useful. I originally discovered the concept of covered call options in Wade B. Cook's book "Wall Street Money Machine, Vol. 1". While Mr. Cook has a bad reputation within the investment community, and has done prison time for tax evasion, his book was an invaluable guide to understanding how covered call options work, and I still believe that it was the best $20 I ever spent on an investment book.

Buying a new car through a broker or a fleet sales manager

One of the most unpleasant experiences we can endure, along with going to the dentist, is buying a new car or truck. Negotiating with a retail car salesman, who's paid on commission, is uncomfortable at best and terrifying at worst.

However, there are at least two other ways to buy a new vehicle. First you can hire an auto broker to find the vehicle and negotiate with the seller. For-profit buying services, big-box warehouse stores like Costco, and many auto insurance companies (like USAA) offer this service. You can also work with a dealership Fleet Sales Manager (FSM), or Internet Manager, and it is this second way that I have used with success.

Basically, the process works like this. After you've identified the make, model and options you want, you contact the dealership FSM, give him the specifics of the vehicle you want. He emails you a quote, which should have both MSRP (Manufacturer's Suggested Retail Price) and Dealer Invoice prices for the vehicle and all the options. The quote should show you what you will pay over/under invoice, along with any factory rebates and incentives, freight charges, taxes, license fees, etc. The quote should also tell you the estimated date the car will arrive at the dealership, since it is being built as a special order for you (I will talk more about this later). If you like the quote, you go to the dealership, meet the FSM, review and sign the purchase order and give him a down payment. Then you wait for the vehicle to arrive, which can take 6 to 12 weeks.

The advantages of buying a vehicle this way are numerous:

(1) You specify the exact vehicle you want... color, upholstery, options, etc.

(2) You don't pay for options you don't need or want.

(3) You won't get a car that has been test driven by potential buyers.

(4) The price is negotiated up from Dealer Invoice, not down from MSRP. There is no supplemental sticker with several thousand dollars of Additional Dealer Markup (ADM).

(5) You don't pay a retail sales commission; the FSM is salaried.

(6) You don't pay dealership "flooring" charges; these include dealership overhead (rent/utilities) and finance charges on the dealer's loan (dealers usually don't own the vehicles on their lots). You will typically pay a regional advertising fee, however.

(7) The end result is that you get exactly the car you want, at a much lower price, with far less hassle.

However, there are disadvantages:

(1) You have to special order the vehicle, and wait for it to arrive.

(2) The FSM will be reluctant to work with you if you have been to the dealership and worked with a retail sales person. Why? Because a deal with the FSM excludes a commission for the retail salesman, and these people all have to work together. As a result, if you want to test drive the vehicle, you need to find a second dealership.

(3) You have to wait 6-12 weeks for delivery

(4) Typically you have an 8-month window for special orders (Oct-May). After May it is difficult to order a vehicle because the production line is shutting down for the annual model-year changeover.

(5) Financing and trade-ins complicate the deal, and I have no experience in this area, mainly because I have always paid cash and never traded in a vehicle.

So, why would a dealership FSM be interested in your business? Because special order vehicles are not considered part of the dealer's "allocation", the number of vehicles of each model that are allocated by the manufacturer to that dealership. Since popular models are always in short supply, the FSM is not taking your order out of that limited supply, so he is not negatively impacting the potential total retail sales commission for the dealership. In addition, special orders increase the total dealership volume, and since next year's allocation is based on this year's sales volume, the dealership allocation for next year will increase.

The bottom line is that, if the advantages outweigh the disadvantages, buying a vehicle through a dealership Fleet Sales Manager is something you should seriously consider.