 for  which  you  must  make  deci-sions? Is this investment method as simple as it appears to be?
In this chapter we’ll take a detailed look at how an investor works witha real portfolio and handles a variety of trading decisions. The results de-scribed are all fictional, but realistically represent the types of situations youface and the decisions that must be made when managing a portfolio of ex-change traded funds (ETFs) and hedging those positions with covered calls.This chapter is important and introduces issues not covered elsewhere.
Even though we discussed how writing uncovered puts can achieve theidentical results with more efficiency, this chapter considers only coveredcall writing because many brokerage houses do not allow their clients tosell uncovered put options, even when they are cash backed. Chapter 16provides  a  similar  discussion  on  put  writing—but  please  don’t  skip  thischapter, as it provides guidance for situations you are certain to face. If youlearn how to write covered calls successfully, then making the adjustmentto writing uncovered puts is not going to be a problem for you.
CHOOSING YOUR PORTFOLIO
For  our  study,  let’s  select  one  of  the  hypothetical  portfolios  created  inChapter 13.
141
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Important note: There is no recommendation that this portfolio is ap-propriate for any investor. It was chosen because it contains a mix of threedifferent ETFs, and trading this portfolio over a one-year period presentsmany different decision-making opportunities. The purpose of this sectionis for you to encounter the types of real-life choices that occur when youuse  the  recommended  strategy.  When  you  understand  the  trading  tech-niques that support the strategy, it becomes much easier to make winningdecisions. This is especially true for those readers who are new to optionstrading.
A  sample  portfolio  stressing  American  mid-caps  and  foreign  stocks
might include:
100  EFA  (an  investment  in  European,  Australasian,  and  Far  Easternstocks)
400 MDY (S&P MidCap 400 index)
400 VTI (Vanguard Total Stock Market VIPERs)
TAKING THE PLUNGE
For simplicity, let’s make these trading assumptions:
• All trades are made online, except where noted. If you prefer to callyour broker to place orders, bear in mind that it takes longer for thoseorders to be executed and the additional cost reduces your profits.• The  commissions  used  are  typical  of  fees  charged  by  some  deep-
discount brokers. Both lower and higher rates are common.• The commission to buy or sell ETFs is $10 per order.• The commission for options is $10 per order plus $1.50 per contract.• Exercise and assignment fees are $20 each.1
• The preferred method is to write options expiring in the front month,
but there may be exceptions.
It’s a brand-new year and you are eager to begin using options. Let’s as-sume it’s a Wednesday in mid-January, and expiration is two days in the fu-ture. You have carefully considered your investment choices and are readyto proceed.
The following narrative is written in the first person, as it representsthe  thought  process  of  the  trader  who  owns  the  portfolio.  That  trader  isnew to covered call writing and is gaining experience as time passes.
A great deal of information is packed into the following discussion. Togain the maximum benefit, go through the trades slowly, and determine ifthe trading decisions make sense to you. This is where you can get a better
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Covered Call Writing In Action
143
feel for the trading style that appeals to you. If the trades illustrated feelright,  you  can  begin  your  option  writing  program  by  adopting  a  similarstyle. If you would be more comfortable writing out of the money (OTM)options and seeking higher potential profits, that provides a hint as to howyou should treat your own investments. Similarly, if you would prefer theadditional safety that comes with writing in-the-money (ITM) options, that’sthe style you should adopt when you begin writing covered calls. It won’ttake long for you to become proficient with making the decisions, enteringthe orders, and managing your positions.
TERMINOLOGY
Each month investments are made on the Monday following expiration Fri-day. In our examples, the initial trades are made in January, but the optionssold expire in February. For the purposes of this discussion, let’s refer tothese trades as February expiration trades even though the positions areinitiated during January.
FEBRUARY EXPIRATION
I have $100,000 to invest and, after careful consideration, I’m going aheadwith the covered call writing program. To have a well-diversified portfolio,I’m including an investment in overseas stocks. Between 10 and 15 percentof my available capital is used to buy 100 shares of EFA. I’m investing thebalance of my money in 400 shares of VTI, as it tracks the entire U.S. stockmarket, and 400 shares of MDY, because I like the idea of owning mid-capstocks. Mid-caps are small enough for future growth, yet they are not asvolatile as smaller capitalization stocks. For each 100 shares of an ETF pur-chased, I’m writing one at-the-money (ATM) call option.
OK, I’m in. I paid $109.00 for 400 shares of VTI and wrote the Feb 109calls  for  $1.80.  The  shares  cost  $43,610,  including  commissions  and  I  re-ceived $704 ($720, less $16 commission) from the option sale.
Likewise,  I  bought  400  shares  of  MDY  (coincidentally  trading  at  thesame  price  of  $109  this  month)  and  100  shares  of  EFA  (paid  $134)  andwrote the Feb 109 and Feb 134 calls respectively.
I  was  able  to  put  almost  all  my  money  to  work,  and  I’m  leaving  theresidual $986.50 in my brokerage account until I have enough to reinvest inadditional ETF shares. In today’s environment of very low interest rates,brokerage houses pay a minuscule rate of interest—one-tenth of 1 percentannually on idle cash, so let’s assume this cash earns no interest (to mini-mize calculations and make the discussion easier to follow).
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My initial trades are listed in Table 15.1A.I’ve decided to begin my option writing program by adopting a middle-of-the-road style. That’s why I’ve written calls that expire in the front month(February) and are at the money for each of my three positions. This givesme  the  chance  to  collect  the  maximum  time  premium  from  writing  op-tions.2 My positions are summarized in Table 15.1B. The table also lists themaximum possible profit I can earn from each position, and that occurs ifI am eventually assigned an exercise notice.
I  realize  I  don’t  have  much  protection  against  loss  if  the  market  de-clines, but the good news is that I’d have no protection at all if holding anunhedged stock portfolio.3 My maximum gain occurs if I am assigned on allthree positions. If that happens, I’ll earn 1.57 percent on my money, afterexpenses. Not exciting, but a decent annualized return (18.84 percent).
I’m  going  to  take  the  time  to  watch  my  positions  closely  as  I  enjoywatching the day-to-day fluctuations of the stock market. I know other in-vestors are better off not thinking about their positions until a day or twobefore expiration, but my personality requires me to constantly be aware ofhow my investments are performing.4 I truly believe this investing methodis going to produce good results.
TABLE 15.1A February Expiration Trades
B/S/W
Qty
BW
BW
BW
4004
4004
1001
SYM
VTIVTI
MDYMDY
EFAEFA
Price
Call
Prem
Comm Invested
109.00
109.00
134.00
Feb 109
1.80
Feb 109
1.85
Feb 134
2.00
Total Invested
CashAcct Value
10.0016.00
10.0016.00
10.0011.50
($43,610.00)$704.00
($43,610.00)$724.00
($13,410.00)$188.50
($99,013.50)
$986.50$100,000.00
B/S/W: Buy, sell, or write. Qty: Shares of ETF or number of option contracts. SYM: ETF trading symbol. Price: Price paid for ETF, per share. Call: Expiration and strike price of option sold. Prem: Option price. Comm: Commission for trade $10 to buy or sell ETF; $10 + $1.50 per contract foroptions.Invested: Cost to buy ETF or cash received from selling calls. Total Invested: Sum of individual position costs. Cash: Residual cash, not invested.Acct Value: Sum of cash and investments in account.
4339_PART4.qxd  11/17/04  12:57 PM  Page 145
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                                                          4339_PART4.qxd  11/17/04  12:57 PM  Page 146
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CREATE YOUR OWN HEDGE FUND
Time passes and nothing dramatic happens during the month. Lookingat my positions after the markets are closed on expiration Friday, I see thattwo of the call options I sold are expiring worthless, but I am going to be as-signed on the EFA call. (For convenience, I’ll use the past tense, assumingI  have  already  been  assigned  on  options  that  are  in  the  money  and  thatOTM options have already expired. In the next chapter, we’ll see that theseassumptions are reasonable but not 100 percent accurate.) The results forthe  January  investments  (February  expiration)  are  listed  in  Table 15.1C.Note: I no longer own any shares of EFA, but have $13,380 cash instead.5
For the past month, the S&P 500 index was down by 1.0 percent, themarkets abroad were about 1 percent higher, and I earned 0.78 percent onmy holdings. Earning any profit when the market declines makes me feelpretty good about my investment methodology. Of course, this is the resultof  only  one  month,  and  I’ll  need  more  time  to  determine  how  satisfyingwriting covered calls on a portfolio of ETFs really is.
Two of my options expired worthless, so on Monday I’ll simply writenew options. Both MDY and VTI are currently priced midway between twostrike prices. If these ETF open essentially unchanged on Monday, I’ll haveto  choose  between  writing  slightly  ITM  or  the  slightly  OTM  options  foreach.  I’ll  make  my  decision  quickly,  so  I  don’t  remain  naked  long  (un-hedged) these ETFs for too long. Of course, if the market is heading higher,the longer I wait to sell calls, the better. Conversely, if the market is de-clining, the longer I wait, the less I’m going to receive when writing the calloption.6 Because I don’t want to get involved with trying to time the market,I’ll get this trade executed within 10 minutes of the opening bell.
EFA is a different situation. That ETF increased in value this month,and I no longer own any shares. I have the choice of investing the proceedsof the sale in a different ETF or maintaining my exposure to foreign mar-kets. For now I’ll stick with owning 100 shares of EFA.
Overall, February expiration was not an exciting month, but I’m verysatisfied with the results. No major investing decisions were necessary, andmy portfolio didn’t require too much of my time.
MARCH EXPIRATION
It’s Monday morning and I’ve made my decisions; I am ready to trade onlineas soon as the market opens.
One word of warning: Be absolutely certain you know whether youroptions have expired and whether you have been assigned per your expec-tations.  If  you  can  view  your  account  online,  that  information  should  beavailable to you sometime on Sunday. But if you do not have access to theInternet or if your broker does not provide that service, you must call your
4339_PART4.qxd  11/17/04  12:57 PM  Page 147
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                                                                    4339_PART4.qxd  11/17/04  12:57 PM  Page 148
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CREATE YOUR OWN HEDGE FUND
broker early enough on Monday morning to allow you to verify your currentpositions and make your trading plans accordingly. Every once in a while,you are going to have an expiration surprise. It is not likely, but sometimesan option that is in the money by a few pennies does not get assigned. It’seven possible to be assigned an exercise notice when an option finishes outof the money by a penny or two. Take nothing for granted, and verify yourpositions before you begin trading on Monday.
Note: If you are planning to call your broker to place orders, you can doit either before or after the market opens. But if you plan on discussing yourtrades with your broker, call early to allow extra time. I recommend thatyou be prepared to tell your broker what you want to do, rather than ask abroker  who  has  not  had  any  time  to  carefully  consider  your  holdings  oryour overall strategy for an opinion.
I’m not thrilled that my ETFs closed midway between two strikes, forcingme to choose between writing a slightly ITM or a slightly OTM option. I’dprefer  the  chance  to  write  an  ATM  option,  but  there’s  nothing  I  can  doabout this situation. Waiting for the market price of the underlying ETF tochange so that it’s near the money is a losing strategy, and I am not going toplay  that  game.7 I’ve  decided  to  adopt  the  more  conservative  style  thismonth and write options that are about a half point in the money ratherthan those that are a half point out of the money.
The S&P futures are almost unchanged this morning, so I anticipate mytwo ETFs will open relatively unchanged. That’s good news, because one ofthe risks of adopting a covered call writing strategy occurs if I choose tohold unhedged positions over the weekend. In other words, once my optionsexpired worthless, I owned the underlying assets (in this case VTI and MDY)outright,  with  no  opportunity  to  write  new  call  options  until  the  marketopened on the Monday following expiration. I could have avoided this risk:Last Friday I could have repurchased the soon-to-be worthless expiring callsand written new calls that expire in March. However, I chose not to do so.(An example of how to roll a position to a later month is presented later.)
It takes about 20 minutes to make the final decisions and make the trades.
I’m sure it will take less time as I gain more experience with the procedure.
VTI opened 5 cents higher ($107.55) than Friday’s close, and I was ableto write the Mar 107 call for $2.15. MDT opened 3 cents lower ($108.49), andI  wrote  the  Mar  108  call  for  $1.85.  I  bought  100  shares  of  EFA,  paying$136.12, and wrote one Mar 136 call for $2.00. The trades are summarized inTable 15.2A.
I  spent  $11,865.50  on  new  investments  for  the  month  and  now  have$2,501.00 in idle cash. Table 15.2B lists my current positions and the profitpotential for the month. Note: The value of the account is $8 more than itwas  last  Friday  because  today’s  opening  prices  and  last  Friday’s  closingprices are not identical. For the purposes of our discussion, the monthly
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Covered Call Writing In Action
149
TABLE 15.2A March Expiration Trades
B/S/W
Qty
SYM
Price
Call
Prem
Comm Invested
W
W
BW
VTIVTI
MDYMDY
EFAEFA
4
4
1001
107.55
108.49
136.12
Mar 107
2.15
16.00
$844.00
Mar 108
1.85
16.00
$724.00
Mar 136
2.00
10.0011.50
($13,622.00)$188.50
Total Invested
($11,865.50)
Cash StartCash Now
$14,366.50$2,501.00
profit/loss (P/L) is calculated based on opening prices on Monday, the daythe  new  positions  are  opened.  The  year-to-date  totals  are  based  on  the$100,000 starting investment.
Because I adopted a more conservative approach by writing (slightly)ITM options, my potential profit is reduced. That’s a price I’m willing to payfor the extra downside protection.
The March expiration period turned out to be a pretty good month forthe American stock market, and the S&P rallied by more than 2 percent.Overseas, the markets held steady. I made my maximum possible profit thismonth, since all my ETF options finished in the money. I’ll have no posi-tions when the market opens next Monday and I’m back where I started, ex-cept there is more cash in my account now. So far I’m ahead by $2,041.00.The results are listed in Table 15.2C. Again, nothing exciting, but I now un-derstand this process better and am able to make my decisions and entermy trades with greater assurance that I know what I’m doing.
APRIL EXPIRATION
I’ve thought about it over the weekend, and I’m going to make a change inmy underlying portfolio. I’ve decided I have too much invested in the mid-cap index so will decrease my investment to only 200 shares. I’ll buy addi-tional shares of VTI with the extra money.
The S&P futures are down fractionally Monday morning, and my planis to write options as close to the money as possible. I could have earnedadditional profits if I had chosen to sell OTM calls last time, but that’s noreason for me to lose my discipline and abandon my objectives. I chose cov-ered call writing because it provides some downside protection along withmore frequent profits, and that insurance is valuable to me.
4339_PART4.qxd  11/17/04  12:57 PM  Page 150
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        4339_PART4.qxd  11/17/04  12:57 PM  Page 152
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As  predicted  by  the  futures,  the  market  opened  calmly  this  morningand I had no trouble executing my trades. The results are listed in Table15.3A.
I now have more money invested in the broad-based Wilshire 5000 andless in mid-cap stocks. For my three positions, I wrote one option that wasout of the money and two that were in the money by a small amount. Thepositions are listed in Table 15.3B.
March turns out to be one of those dreary months for the market. Theaverages begin the month lower and slowly continue lower with no con-viction. By the time expiration arrives, the S&P 500 is down almost 3 per-cent, and the options I wrote on VTI and MDY expired worthless. The brightspot for the month was the overseas markets, which increased in value, andmy EFA calls finished in the money. The investment results are listed inTable 15.3C.
This was one of those months that illustrates the value of diversifica-tion in reducing overall market risk. My small EFA profit partially offset myother losses. Of course, asset allocation won’t always work this way. I’msure there will be times when my U.S. investments outperform those fromoverseas. But my purpose is minimization of risk, and investing a portion ofmy