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 in security and dignity and fulfill their religious and moral obligations towards charitable activities)

(Continued from last week)

Another way of looking at this is to say I am losing on the stock price. Remember, we bought the stock at $28 and I sold it at %25. In anyone`s book this would be calculated as a $3 loss. Question. “Do you have the right to lose on a stock price?” The answer is “Yes”. But, it`s not as bad as it looks. You see, in fact, we are pre-capturing part of the profits in the stock, or the last run-up in the stock.

When I say I own the stock at $28, I do not mean we bought the stock at $28. I could have purchased this stock at $24 or $26. I would have to then consider the price at which I purchased the stock and the price at which I sold the stock in order to determine my profits. Let`s say for example that I bought the stock at $24 and I have seen it run up to $28. If I were to simply sell the stock in this case, I would have a $4,000 profit. Let`s better with writing the covered call.

I will take the some stock, different example, in that I was going to buy the stock this time at $24. When the stock hits $28, I sell the $25 call for $4. This would generate $4 of profit. If the stock stays above $25 before the expiration date or even on the expiration date, and I get called out, I would then generate another $1 in capital gains. My total profits would be $5,000. This is a mild example. There are many examples where the option premiums are substantially more than $4, when the stock is $3 in-the-money. When using this lower-profit example, you can see that writing covered calls is a method of enhancing the assets in your account. We simply generate more cash into the account.

Now let`s see what happens if the stock drops back below $25. If it happens on or around the expiration date I would not get called out of the stock. I would still own the stock and could then write more covered calls. I could do so right now by:

(a) Writing a further-out covered call. Instead of writing again for the one week left until this month`s expiration, we could write the call out for two or three months, thereby generating a larger option premium, which puts cash into our account.

(b) If the stock acts like it`s going to rise again, I could put in our order to sell the $25 call, or just wait it out and sell the $25 call on the next rise in the stock

(c) If the stock is showing signs of weakness, I could sell the $25 call. Or, maybe it would be better to sell the $22.50 call. Once again, picking up a larger premium now and getting called out at the $22.50 price if the stock continues to slide depending on where the stock was on the expiration date, we would either keep or sell the stock.

(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.) (To be continued)

 

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Editor: Akhtar M. Faruqui
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