I'd like to explore with you why Writing Covered Calls (WCC) works. I will try a whole new approach to this way of getting the stock market to actually make money for us. A one sentence strategy definition: WCC means we own a stock and then sell for cash an option, giving someone the right to buy our stock at a price we like. It’s kind of like Rental Stocks.
Covered Calls work because of this: We are buying a fixed price investment, the stock, and then selling "fluff," or the volatility in the option. I'll explain more later. Let's say you buy JC Penny (JCP) at $7.10. The next month $7 calls are going for 70¢ to sell. If you have 1,000 shares, it would have cost you $7,100. Now you can sell ten contracts (covering 1,000 shares) of the next month out options for $700. Make sure you get these numbers into your head before you go on. Someone whom you do not know is willingly to pay $700 for the right to buy 1,000 shares at $7. You get to keep the $700 no matter what. If you do sell the stock, you’ll lose the $100, netting $600.
Now, what might happen? The stock is going to go up, down, or stay about the same. The option is a derivative; it is largely based on the price and movement of underlying stock. If the stock moves up or down a lot, the option will also move, oftentimes in an exaggerated manner. Much of the option price is derived (hence a derivative) from the stock price.
What makes up the option price?
That is the key question. In this case there is an in-the-money portion, or 10¢. In-the-Money means the amount the stock price is above the strike price. What about the other 60¢? That's $600 of the $700. This is called the time-value, or sometimes just time. It is the out-of-the-money portion. Time value is made up of three things: 1) Time to expiration; 2) A constant for the math to work, in this case the T-Bill rate; and 3) The implied volatility, the speculative value, what I call fluff. It is someone's opinion of the potential movement of this stock. I think this speculative value can make up about 60% to 80% of the 70¢ cents.
Let's say a guy wants to buy a call option? He thinks the stock to go up. Think about how he makes money. The stock has to go up and go up quickly or he will lose all or part of what he spent on the option. If the stock stays the same or goes down, he will lose. I only recommend straight option trading for more experienced investors, those who are a bit crazy, and those who have money to burn. Most people lose money at straight option trading.
In the last paragraph, do you see how our Mr. Trader can lose money? However, if we're on the opposite side of the trade, we would make money—on this same set of circumstances.
We own the stock, we're covered. We sell the option and pocket the cash. Now, what do we care what the stock does? If the stock stays above $7, we will get called out (not always true—once you learn about the buy-back—you can make even more money this month). No matter what, we get to keep the $700 for selling the option. Not bad for a four-week trade. They take the risk; we take their money.
Is this example unique? Not in the least. We have about 10 that we're looking at right now. Obviously there are many more. That’s what WIN’s TDT is about—finding and sharing these profitable trades. And we can determine every price involved in this process before we get involved.
I'll repeat. WCC works because we buy the stock at a set price. We then sell the option with all the "fluff" contained therein and pocket the cash. We like pocketing the cash.