A Simple Yet Profitable Call Option Strategy

The other day I was talking with a good friend named Adam about options trading. Adam use to work for a pension fund, but now crunches housing data for a think tank in Washington, D.C. When it comes to investing, he is one of the smartest guys I know, and he’s done very well for himself. Anyway, he described for me a simple options trading strategy he uses involving call options that I want to share with you.

Before I get to the options strategy, let me first say that I’ve never dabbled in options. Until recently, I viewed options as extremely risky and pointless for a buy and hold investor. That will change in 2010 for several reasons.

First, options don’t have to be risky. Like most investments, it depends on what you invest in and what investment strategy you pursue.

Second, a lot of money can be made with options trading. Of course, it can be lost as well, which is why I’ll move cautiously into options. I’m not going to sink a large chunk of our portfolio into a complex options trade. With that said, let’s move to covered calls.

A call option is a contract between two parties to buy shares at a specified time and price. The buyer of a call option gets the right, but not the obligation, to buy shares of a stock held by the seller at a given price. And call options also have a time limit. If the buyer does not exercise the option within the given time limit, the call option contract automatically expires. A single option contract overs 100 shares of the underlying security.


An example will help explain how call options work. Let’s assume that company XYZ is trading at $40 a share. A call option contract might price at $42 for the next month at a cost of $1.50 per share (I’m making the numbers up, of course, but it should give you an idea). This means that the buyer is getting the right, but not the obligation, to buy 100 shares of XYZ company for $42 a share within the next month. The cost of the option contract is $1.50 a share, or $150 ($1.50 x 100 shares).

If the price stays flat or goes down, the buyer of a call option won’t exercise the option. On the other hand, if the price goes up over $42 a share, the buyer will exercise the option.

My friend Adam regularly sells call options. Recently he bought ETF shares in silver and has been selling short term calls. Because the price of silver has remained relatively flat, he’s collected the option contract price and kept his shares in the ETF. It’s kind of like renting out your shares and giving the renter an option to buy at an agreed price.

So what are the risks? The primary risk is that the value of the security will go up substantially, and you will lose out on the gain. In our example, if the share price of XYZ company shot up to $50, you would still be required to sell the stock at $42. You wouldn’t “lose” money in the sense of a cash outlay, but you would obviously be selling stock for less than it’s worth. On the upside, if you think the price of the security will remain stable, it can be a great way to generate passive income off of your stock holdings.

To learn more about options trading, I’ve signed up for an account with OptionsXpress. You can open an account without depositing funds, and then a host of tools and resources become available for free. We published a review of OptionsXpress today, which provides more information on what the online options broker has to offer.

Topics: Investing

5 Responses to “A Simple Yet Profitable Call Option Strategy”

  1. DR,

    I LOVE selling covered calls. You don’t have go that deep to start out. For instance I bought FRE (Freddie Mac) and keep selling covered calls about 50 cents away from the price of the stock (closed today at 1.38) for .15 – getting me $15 – with an expiration of 30 to 45 days away. While this isn’t a lot I keep doing it over and over with a bunch of different stocks.

    There is a whole lot more into it that I don’t fully understand with Deltas and stuff. Tradeking (who I use) has TONS of great stuff for newbies.

    The other risk that you missed was that the stock drops substantially – since you are in mid-contract you won’t be able to sell the underlying stock.

  2. Evan, nice point on the risk of the stock dropping. Since I only buy long, and call option contracts are short in duration, this risk isn’t a big concern for me. But it is certainly something to consider.

  3. I’ve done this on and off for awhile, and I’d like to give a couple of additional caveats.

    – There’s no sure thing. Even if you’re playing it “safe” as in Evan’s strategy, one big hit will wipe out all of those slow but steady gains and then some.

    In your example of the $42 strike price on a $40 stock, remember that the downside that you mentioned (the stock goes up to $50) means that you’ve lost $650 (you would have to buy back the calls at $800 before expiration), which wipes of four rounds of the safe $150 gains.

    And unlike buying calls or stocks, you’re “naked” with your investment, meaning you can lose a lot more than your initial investment. If you sell your $1.50 calls on that $42 stock and the next day they announce that they’re being bought out at $70/share, you’re out $2800.

    – Every company does it differently, but the reserve requirement in your account is usually based on the value of the underlying security. So, in order to sell just one of those calls for $150, the broker will protect their own ass(ets) by requiring you to have a some percentage of the value of the underlying value of the securities covered in the form of cash/stocks in your account that could be liquidated if need be. Not that big of a deal, but it may tie up some money that you would like to have working for you somewhere else.

    It’s a strategy that can work for you, but don’t be lulled into thinking that it’s a simple, low-risk strategy. Tread carefully.

    • Hulk, thanks for the information. There’s no question that like all investing, call options have risks. One thing I wanted to note, however, is that I’m not suggesting buying naked calls. Perhaps I should have made that more clear, but this strategy assumes that the investor owns 100 shares of whatever company they are selling call options on.

      For those wondering what a naked call is, it’s simply selling a call option when you don’t own the underlying stock. Would never recommend it.

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