Premium of Selling in-The-Money Calls
It`s All about Monthly Cash Flow
By Saghir Aslam
Rawalpindi, Pakistan

 

(The following information is provided solely to educate the Muslim community about investing and financial planning. It is hoped that the Ummah will benefit from this effort through greater financial empowerment, enabling the community to live with dignity and fulfill their moral obligations towards charitable activities)

 

(continued…)

WHY DO THIS?

By selling an in-the-money call, we are simply generating more cash into the account. If that is important to you, then this just might be the way to go. In some regards, it is better to do so, for instance, when the cash in your account could be better used to serve other purposes. Let`s stick to a pure comparison of the $28 stock.

A. Stock is at $28 and we write the $30 call. We sell for $2 and with 1,000 shares of the stock, we sell ten contracts and generate $2,000. We have agreed to give up everything above $30. If the stock does not rise above $30, we keep the stock and we keep the $2,000.

We would still have the stock and could write more covered calls in the future.

B. We write the $25 call for $ we write the $25 call for $4. We generate more cash into the account (the $4,000). We are giving back everything in the stock above the $25 strike price. The extra cash can be used for other stock purchases or even other option purchases. We would execute this strategy when we want to get called out of the stock.

Now let`s take another look at both the transactions in Column A and Column B above, from A rate of return point of view. Many of you will not use margin. Margin means you would borrow half of the stock price from the stockbroker. However, many people use purchasing so that they only have half of the amount of money tied up.

We will buy the $28 stock for $28 and use a margin for this purchase. In the case, with purchasing $1,000 shares, we will put up $14,000 and our broker will loan us the other $14,000. Now let1s go back through Column A and Column B.

A. If we purchase a stock at $28 and sell it for we would keep the $2,000 from selling the $30, we would have a $2 capital gain and we would keep the $2,000 from selling the $30 call.

We would have $4,000 profit. On our $14,000 investment, that would represent a rate of return of 20%. This was a three- or four-week trade. If you offset the amount of your own personal cash you have tied up, you`ll see a slight change in the rate of return. You would take the $4,000 profit and divide it by $12,000. The reason we would only use $12,000, is because the $2,000 we generated by writing the covered call is just cash in the account. The computer at your brokerage will do what is best with that money on your behalf. Basically, it would lower the amount of margin your broker is putting into the trade.

  • If we sell the $25 call and get called out at $25. The rate of return would be 7%. When we write a covered call in this example, our only profits are going to be the option premium. In fact, we`re going to lose money on the stock purchase, and we`ll subtract that from the option premium of $4. The loss would be $3 from the $4, which leaves us with $1, or a $1,000 profit. We would then take the $1,000 in profit and divide it by the $14,000, for a rate of return of 7%, or we would use the $4,000 to offset our $14,000 for the stock purchase, and divide the $1,000 by $10,000, for a 10% rate of return. It doesn`t sound like much, but remember, this is three to four week trade, and I must add, there is more certainty in this trade. Nothing is ever one-hundred percent certain, but there is a higher likelihood of getting called out at $25 than there is of getting called out at $30.

(To be continued…)

(Saghir A. Aslam only explains strategies and formulas that he has been using. He is merely providing information, and NO ADVICE is given. Mr Aslam does not endorse or recommend any broker, brokerage firm, or any investment at all, nor does he suggest that anyone will earn a profit when or if they purchase stocks, bonds or any other investments. All stocks or investment vehicles mentioned are for illustrative purposes only. Mr Aslam is not an attorney, accountant, real estate broker, stockbroker, investment advisor, or certified financial planner. Mr Aslam does not have anything for sale.)

 

-----------------------------------------------------------------------------

Editor: Akhtar M. Faruqui
2004 pakistanlink.com . All Rights Reserved.