C.S. Hsia's Blog

I’ve been investing in the stock market for over 15 years now, and weathered the ups and downs of the market quite a few times. My investment style can be described as cautious, and based on fundamental analysis. I’d say on average, I trade around 30-40 times a year.

6 years ago, a family friend suggested that we write covered calls to earn some extra cash. Despite my then 9 years of experience trading equities, the concept of options trading seemed intimidating. As anyone who dared to click on the options link in their online brokerage account can attest, looking at that stuff can be quite daunting to the average equity (stock) investor.

Then one day, driven by the need for cash, I decided to cautiously give it a go, referencing various online websites for suggestions throughout the way. From that day on, I have been selling covered call options monthly and generating about 1-2% of the portfolio value in cash every month. That’s a pretty impressive 12~24% every year! All without changing my basic investment strategy, and still getting the capital gains of my stock investments(or losses). Now let me talk about how it is done.

1. Know what is an option.
Options are measured in contracts. Here are some bullet points to remember:

• Each contract = 100 shares
• An option contract is the right to buy/sell at a specific time in the future, at a specific price…
• … where the Strike Price is the specific price
• Contracts for the specific month expire the third Friday of said month
• Based on the Strike Price and Expiration Date, the “contract” will have different values
• Values of contract (premium), or the price they trade at, is determined by the market (like stocks)
• Call options are the right to buy.
• You can buy the options (own it), or you can write/sell the options to someone. Owner of the option has the right to “exercise” the option and request to buy the stock at the specific price.
• Quick Example: A March 150 Apple Call Option is the right to buy 100 shares of Apple Inc. before the third Friday of March, at $150 a share. If Apple is worth 200 a share, this option will be worth a lot, if Apple is $30, then the contract is pretty much worthless.

2. Getting Started on Covered Call Writing.
You need an online brokerage account if you don’t already have one. Give Firstrade a try, rated #1 by a leading online publication recently. Request for covered call writing option privileges. Now in order to write covered calls, you need to have stocks in your account. You can buy stocks for the sake of selling covered calls, or just write calls against what you already own. Like I said earlier, 100 shares = 1 contract, so you need at least 100 shares of the same security.

3. Write the right call.
Lets assume you own 100 shares of Apple that you bought years ago at $50. It’s currently at $95. You’ve had it in your account, just sitting there for the longest time but do NOT want to sell. It’s time to put the stocks to work.

1. Get an option-chain for Apple for the next calendar month.
2. Focus on the call options (we’ll explain puts on some other date).
3. You will see prices for AAPL at various “Strike Prices”. Assume you think Apple will linger around $95~$100 for the coming month, check the premium for AAPL $105 strike. (97 cents as of now)
4. That means enough people are betting that Apple will exceed $105 by the 3rd friday of next month that they’re willing to buy the RIGHT of that transaction from you, TODAY!
5. You sell the option at the market price of $0.97. Multiply that by the 100 shares, and you pocket $97 minus commissions ($7.70)
6. You pocket $89.30. Money in the bank. Cha-Ching! That’s yours, no matter what happens from here.

4. Watch What Happens.
You have sold one contract, which means that if Apple goes above $105 before the 3rd Friday of next month, someone can buy your 100 shares at $105. If Apple goes to $150, then you forgo some pretty big gains. But it’s still profit considering you bought at $50.

Now if Apple ends the month at $105 or below. The contract expires, you owe nothing again. $89.30 still in the bank. Life is good.

5. Rince, Repeat, 12 Times a Year?
For volatile stocks, there’s a lot of premium (value) for contracts that have strike prices above the market price. You can essentially write one call for each month. Less volatile stocks have less movement in price, so you might need to sell/write the right of the stock 2 or 3 months from today to find a decent premium. In the Apple example, IF you are able to do this 12 times a year, that’s around $1000! Almost 10% returns, without selling the stock. Interesting eh?

Not too difficult right?

Now before I go any further, I must stress that like everything else in life, this needs practice for you to become familiar. Covered calls are relatively safe for options, but there are risks still. Your shares of Apple can go down (you lose money on the stock, options are fine), or your shares could soar (you forgo gains). Or if your stocks are currently in the red, and your option gets exercised, you are essentially forced to sell at a loss.

Options is not for everyone, but with proper knowledge I think covered calls are no more difficult than stocks or mutual funds. As you gain more experience, you will slowly see the trends of option prices. Sometimes I buy back the option when it’s losing value, and sell/write another covered call on the same stock, for the same month. Double the gains (If you don’t know what I mean by that, you will after some practice and experience). Feel free to comment or ask questions below!