calculate the breakeven, we add the option’s strike price to the con-tract price, or 17.50 plus 2.55. The breakeven equals $20.05 a share. Often,
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traders will exit the long call strategy before expiration if the stock movesdramatically higher or falls too far below the breakeven. Recall that timedecay is the greatest during the last 30 days of an option’s life. Therefore,it is best not to hold an option like the long call during that time. In addi-tion, many traders will exit the position if it does not move in the antici-pated direction. For example, if INTC drops below $15 a share, the tradermight choose to close the trade. In that case, the $15 level would be con-sidered a stop loss, or a predetermined price point where the trader exits alosing trade. In any case, rarely will the long call be exercised when it ispurchased in anticipation of a move higher in the underlying security. In-stead, the position is closed through an offsetting transaction. Speciﬁcally,you will sell 10 INTC January 17.50 calls to close.
The  chart  in  Figure  4.9  shows  the  risk  graph  for  the  INTC  January
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FIGURE 4.9 Risk Graph of Long INTC Call (Source: Optionetics Platinum © 2004)
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Long Call Case Study
Strategy: With the stock trading near $16 a share in February 2003, buy10 INTC January 17.50 calls @ $2.55 and hold until the end of the year.
Market  Opportunity: The  stock  looks  bullish  and  is  expected  to  riseabove $20 a share by January.
Maximum Risk: Limited to the amount paid for 10 calls or $2,550.
Maximum  Proﬁt: Unlimited  as  the  price  of  the  underlying  instrumentrises  above  the  breakeven.  In  this  case,  the  INTC  January  17.50  calltopped $30 a contract for an 11-month gain of 600 percent.
Breakeven: Strike price + call option premium. In this case, 20.05: (17.50+ 2.55).
Margin: None.
17.50 long call at the time the trade was established. We can see that if thestock falls the call will lose value. In contrast, proﬁts begin to build as thestock moves higher. The maximum risk is equal to the premium, or $255per contract. The upside potential is quite large. In fact, in this case, Intelnot only rose above $20 a share that year, it topped $30. As a result, by theend of the year, the INTC January 17.50 call was worth $17.50 a contract—for an 11-month 600 percent gain!
Long Call versus Long Stock
As you can see, a long call strategy has many advantages compared withbuying stock. For clarity’s sake, let’s review these advantages.
• Cost. The premium of an option is signiﬁcantly lower than the amount
required to purchase a stock.
• Limited risk. Since the maximum risk on a long call strategy is equalto  the  premium  paid  for  the  option,  you  know  before  entering  thetrade exactly how much money you could potentially lose.
• Unlimited  reward. Once  you  hit  breakeven  (call  strike  price  +  calloption premium = breakeven), you have unlimited reward potential asin a stock purchase.
• Increased  leverage. Less  initial  investment  also  means  that  you  canleverage your money a great deal more than the 2-for-1 leverage buy-ing stock on margin offers.
The only drawback is that options have a limited time until they ex-pire. But even this disadvantage can be seen as an advantage if you con-sider the opportunity cost of waiting months and sometimes years for astock that has taken a bearish turn to reverse direction.
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SHORT CALL
In a short call trade, you are selling call options on futures or stock con-tracts. This strategy is placed when you expect the price of the underlyinginstrument  to  fall.  If  you  want  to  go  short  a  call,  your  risk  curve  wouldlook like the graph in Figure 4.10. If you want to short a stock, your riskcurve would fall from the upper left-hand corner to the lower right-handcorner  (see  Figure  4.10).  Notice  how  the  horizontal  line  slants  upwardfrom right to left, providing insight as to its bearish nature. When the un-derlying instrument’s price falls, you make money; when it rises, you losemoney. This strategy provides limited proﬁt potential with unlimited risk.It is often used to get high leverage on an underlying security that youexpect to decrease in price.
Selling a call enables traders to proﬁt from a decrease in the underly-ing  market.  If  the  underlying  stock  stays  below  the  strike  price  of  theshort call until the option’s expiration, the option expires worthless andthe trader gets to keep the credit received. But if the price of the underly-ing  stock  rises  above  the  short  call  strike  price  before  expiration,  theshort  option  will  be  assigned  to  an  option  buyer.  A  call  buyer  (as  dis-cussed in the previous section on long calls) has the right to buy the un-derlying  asset  at  the  call  strike  price  at  any  time  before  expiration  byexercising the call. If the assigned call buyer exercises the option, the op-tion seller is obligated to deliver 100 shares of the underlying stock to the
FIGURE 4.10 Short Call Risk Graph
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option buyer at the short call strike price. This entails buying the underly-ing stock at the higher price and delivering it to the option buyer at thelower  price.  The  difference  between  these  two  prices  constitutes  theseller’s loss and the buyer’s open position proﬁt. This can be a huge lossin  fast  markets,  which  is  why  we  never  recommend  selling  short,  or“naked,” options.
Selling naked calls is not allowed by many brokerages. Some may re-quire  you  to  have  at  least  $50,000  as  a  margin  deposit.  This  speaks  vol-umes about just how risky this strategy can be. However, since a short callis very useful in hedging and combination options strategies, it is impor-tant to understand its basic properties.
In the case of selling options, be advised that you will initially receivemoney into your account in the form of a credit. This is the premium forwhich you sold the option. This strategy is used to generate income fromthe  short  sale  of  an  option,  since  it  provides  immediate  premium  to  theseller. In addition, it’s best to short calls when the implied volatility of theoption is high; that way, you maximize the premium received. This is vitalsince the proﬁt on a short call is limited to the premium received, and theposition has an unlimited upside risk. As you can see by looking at the riskgraph  in  Figure  4.10,  this  is  a  very  risky  strategy  because  it  leaves  thetrader completely unprotected.
Short Call Mechanics
Let’s  create  an  example  that  shows  the  trader  going  short  1  Jan  XYZ  50Call @ 5.00. The trader collected $500 (5 × 100 = 500) minus commissionsfor this trade. The maximum reward is limited to the credit the trader re-ceives at the trade’s initiation. Conversely, the risk on this trade is unlim-ited  as  the  price  of  the  underlying  asset  rises  above  the  breakeven.  Thebreakeven of a short call equals the strike price of the call option plus thecall premium. In this trade, the breakeven at expiration is 55: (50 + 5 = 55).As  the  market  drops,  the  position  increases  until  it  hits  the  maximumcredit (i.e., the amount of premium taken in for the call. Please note that ashort call comes with unlimited risk to the upside. It is very important thatyou learn how to create covered positions (i.e., sell an option and buy anoption) to limit your risk and protect against unlimited loss.
Figure 4.10 shows the risk proﬁle of the short call position. When theunderlying  stock  reaches  a  price  of  50,  the  position’s  proﬁt  hits  a  maxi-mum  of  $500  (the  credit  received).  The  call’s  potential  loss  is  unlimitedand continues to increase as the price of the underlying asset rises abovethe $55 breakeven. If the market price of the underlying asset doesn’t rise,you get to keep the credit. However, this is the most that can be made onthe trade.
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A short call strategy offers three distinct exit scenarios. Each scenario pri-marily depends on the movement of the underlying shares.
• XYZ falls below the call strike price (50): This is the best exit strat-egy. The call expires worthless at expiration. This means you get to keepthe premium, which is the maximum proﬁt on a short call position.
• XYZ  rises  above  the  call  strike  price  (50): The  call  will  be  as-signed to a call holder. In this scenario, the call seller is obligated todeliver  100  shares  of  XYZ  at  $50  per  share  to  the  assigned  optionholder by purchasing 100 shares of XYZ at the current market price.The  difference  between  the  current  market  price  and  the  deliveryprice  of  $50  a  share  constitutes  the  loss  (minus  the  credit  of  $500initially received for shorting the call).
• XYZ  starts  to  rise  above  the  breakeven  (55): You may want tooffset  the  position  by  purchasing  a  call  option  with  the  same  strikeprice and expiration to exit the trade because assignment becomes in-creasingly likely once the time value of an option falls below 1/4 point.
Short Call Case Study
When  looking  for  short  call  candidates,  what  we  want  to  see  is  a  stockthat has run into resistance and that is expected to move lower before op-tion expiration. Since we are selling the call, we also want to use time de-cay to our advantage by selling front month options. Lastly, we are lookingfor a stock that has options that are showing high implied volatility (IV)compared  to  the  past.  The  higher  the  IV,  the  larger  the  premium  we  re-ceive up front. Let’s look at a real-world example for a short call.
In late May 2003, we could have run a search for stocks that had op-tions showing high implied volatility. One stock that would have shown up
Short Call
Strategy: Sell a call option.
Market  Opportunity: Look  for  a  bearish  or  stable  market  where  youanticipate a fall in the price of the underlying below the breakeven.
Maximum Risk: Unlimited as the stock price rises above the breakeven.
Maximum  Proﬁt: Limited  to  the  credit  received  from  the  call  optionpremium.
Breakeven: Call strike price + call option premium.
Margin: Required. Amount subject to broker’s discretion.
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was Northrop Grumman (NOC). On May 26, NOC spiked higher, but raninto resistance near $90.
By  entering  a  short  call,  we  have  unlimited  risk  to  the  upside.  Thismeans that if the stock moves sharply higher, we have to come up with themoney to cover the call. However, we get a credit immediately from thesale of the call, though margin will be needed. In our example, NOC was at$87.96 as of the close of trading on May 27. At that time, we could havesold the June 90 call for $1.10, or $110 per contract. In this case, our maxi-mum risk is unlimited as the stock rises and our maximum proﬁt is the ini-tial credit received. Our breakeven point is found by adding the credit wereceived  (1.10)  to  the  strike  price  of  90:  (1.10  +  90  =  91.10).  Thus,  thebreakeven point as of expiration is at $91.10.
By looking at the risk graph in Figure 4.11, notice how the proﬁt area
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FIGURE 4.11 Risk Graph of NOC Short Call (Source: Optionetics Platinum © 2004)
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Short Call Case Study
Strategy: With the stock trading near $88 a share on May 27, 2003, sell10 June 90 calls @ 1.10 and hold until expiration.
Market Opportunity: NOC has run into resistance and looks like it is in adowntrend.
Maximum Risk: Unlimited to the upside above the breakeven.
Maximum Proﬁt: Net credit initially received. In this case, $1,110: ($110× 10 = $1,110).
Breakeven: Strike price + call option credit. In this case, 91.10: (90 + 1.10).
Margin: Extensive.
is small when compared to the loss area. This occurs because the tradehas unlimited risk as the stock rises. For most traders, this type of trade istoo risky to undertake and it requires a lot of capital to be held in margin.Nonetheless,  for  the  trader  who  has  the  funds  and  uses  appropriatemoney management, a short call can be proﬁtable.
In  our  example,  shares  of  NOC  remained  below  $90  all  the  waythrough June expiration on June 20. In fact, the stock was making a movehigher when expiration hit, but this trade still would have closed with amaximum proﬁt of $110 per contract.
COVERED CALL
Covered call writing (selling) is the strategy that seems to be promotedmost  by  the  investment  community.  Many  stockbrokers  use  this  tech-nique  as  their  primary  options  strategy,  perhaps  because  it  is  the  onetechnique  they  are  trained  to  share  with  their  clients.  It  is  also  widelyused by many so-called professional managers. Nevertheless, it can be adangerous strategy for those who do not understand the risks involved. Afew publications describe this technique as a “get rich quick” method forinvesting in the stock market, but it can become a “get poor quick” strat-egy if done incorrectly.
What is this technique all about? The purpose of the covered call isto  increase  cash  income  from  a  long  stock  or  futures  position.  It  pro-vides some protection against decreases in the price of a long underlyingposition or increases in the price of a short underlying position. A cov-ered call has limited proﬁt potential and can result in substantial losses;but  these  potential  losses  are  less  than  those  for  an  unprotected  longstock or futures position.
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A  covered  call  write  is  composed  of  the  purchase  of  a  stock  (or  fu-tures contract) and the sale of a call option against the purchased underly-ing  asset.  Remember,  the  buyer  of  a  call  option  has  the  right  to  call  theoption seller (writer) to deliver the stock at the price at which the optionwas purchased. Therefore, if you write an option you are the seller, andyou  are  responsible  for  delivering  the  stock  at  the  strike  price  at  whichthe option was sold to the purchaser if the option is exercised. At the in-ception of the transaction, you receive a premium, which pays you for thetime value of the option as well as any intrinsic value the option may haveat that time.
You may be wondering what is wrong with the whole concept of cov-ered  call  writing.  Why  are  so  many  people  incorrect  when  they  use  thisstrategy?  Many  traders  simply  do  not  know  the  risks  they  are  assumingwhen they implement this overused technique. If you placed covered callsin  stocks  that  only  go  up,  you  could  make  out  very  well.  However,  howmany people pick stocks that only go up?
A  range-bound  stock  exhibits  price  action  between  two  speciﬁedpoints:  resistance  and  support.  Resistance  is  the  point  at  which  pricesstop rising and tend to start to drop. Support is the point at which pricesstop dropping and tend to start to rise. When a stock rises, it hits a cer-tain  price  where  the  sellers  rush  in,  outnumbering  the  buyers,  andthereby causing prices to start to fall off. The support level is the placewhere the price has become low enough for buyers to start to outnum-ber  the  sellers  and  the  price  begins  to  rise  again.  If  this  recurs  over  aspeciﬁed period of time (e.g., six months), strong support and resistancelevels have probably been established. Stocks that exhibit these tenden-cies can be excellent candidates for covered call writing. However, youmust be aware that nontrending stocks also can begin trends, and manymay begin trending to the downside.
Covered Call Mechanics
Let’s  create  a  hypothetical  example  using  a  technology  stock  with  thename XYZ Computer Corp. The ticker symbol for shares is XYZ and thecompany is one of the world’s leading computer sellers. The company hasperformed exceptionally well, with shares rising more than 400 percent ina one-year period! Let’s say XYZ Computer is trading at $49 per share afternumerous stock bonuses, and we decide to place a covered call trade.
Let’s buy 100 shares of XYZ at $49 each. This part of the trade costs$4,900 ($49 × 100 = $4,900). The amount of margin (the capital required)would be half this amount, or $2,450. In a covered call strategy, a traderoffsets the purchase cost of shares with the sale of a call option. The cov-ered call consists of selling one call for each 100 shares owned. The call
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can  have  any  strike  price  and  any  expiration;  however,  this  step  can  bedifﬁcult. You have to choose which option to sell. You have a multitude ofchoices:  near-term,  long-term,  in-the-money,  out-of-the-money,  at-the-money,  and  so  on.  Many  covered  call  writers  sell  options  one  or  twostrikes  out-of-the-money  (OTM)  because  they  want  the  shares  to  have  alittle room to run up before reaching the strike price at which the optionwas sold.
Let’s say that on September 9, XYZ is trading at $49, and the October50 and 55 call options (which have 40 days to expiration) have the follow-ing option premiums:
• October 50 Call @ 2.75.• October 55 Call @ 1.75.
In this example, let’s go long 100 shares of XYZ at $49 and short 1 XYZOctober  50  call  at  $2.75.  This  transaction  has  two  sides,  the  debit  (pur-chase of shares) and the credit (sale of option). The debit equals $4,900($49 × 100 = $4,900); however, the amount of margin (the capital requiredto place the trade) would be half this amount, or $2,450. In addition, youwould receive a $275 credit (2.75 × $100 = $275) for the short option on100 shares of stock. The risk proﬁle for this trade is shown in Figure 4.12.If the stock rises from $49 to $50, the strike price of the option, you
FIGURE 4.12 Covered Call Risk Graph
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make  an  additional  $100.  You  also  get  to  keep  the  $275  credit  you  re-ceived. In total, your proﬁt will be $375. If the stock goes to $55 you stillget $375. If the shares go to $100 you still get only $375. In both these in-stances, you have to deliver the shares to the assigned purchaser of theoption  as  it  will  be  exercised  at  expiration  since  the  option  is  in-the-money (i.e., the share price is greater than the strike price of the option).That means that for an investment of $2,075: ($2,450 – $375 = $2,075), youcan make $375 if the stock rises to at least $50 by expiration—a 17 per-cent return in only 40 days.
Lastly, the breakeven of a covered call is calculated by subtracting thecredit received on the short call from the price of the underlying securityat trade initiation. In this trade, the breakeven is 46.25: (49 – 2.75 = 46.25).In Figure 4.12, the risk graph for the covered call example, notice howthe proﬁt line slopes upward from left to right, conveying the trader’s de-sire  for  the  market  price  of  the  stock  to  rise  slightly.  It  also  shows  thetrade’s limited protection. As XYZ declines beyond the breakeven (47.25),the value of the stock position plummets as it falls to zero. Thus, the inherentrisk in this strategy rears its ugly head.
Overall, the covered call offers a slightly better approach than if yousimply purchase the stock at $49 and watch it drop, because you have re-duced your breakeven price by 2.75 points. XYZ must drop below this newbreakeven  price  (46.25)  to  start  losing  money  at  expiration.  But  once  itfalls below the breakeven, losses can accumulate quickly.
Now  let’s  say  you  sell  the  October  55  calls  at  1.75;  then  yourbreakeven price is higher at $47.25 ($49 less the 1.75 received for sellingthe 55 call). By selecting the higher strike call option to sell, you will re-ceive  less  of  a  credit  and  will  raise  your  breakeven  price  for  the  stock.However,  then  you  have  a  greater  potential  return  on  the  investment  ifand when the stock goes up. Obviously, you lose money when the stockgoes  below  the  breakeven  price.  Bottom  line:  each  option  has  a  certaintrade-off for the option writer. You have to decide which one best ﬁts themarket you are trading.
As mentioned previously, if the price of XYZ stock has been going upsigniﬁcantly over the past year, covered call writing would not have hurtyou. You may not have received the 400 percent gain stock purchasers re-ceived,  but  perhaps  you  could  have  slept  better  at  night,  as  you  wouldhave  reduced  your  breakeven  point.  Unfortunately,  traders  may  selectstocks  that  have  just  begun  a  tailspin  and  lose  50  percent  of  their  valueovernight.  In  these  cases,  a  covered  call  strategy  will  not  help.  Thesetraders may get to keep the short option’s credit, but that will not go veryfar  in  light  of  losing  50  percent  or  more  on  the  total  price  of  the  stock.There are numerous examples of companies losing 30 percent, 40 percent,75 percent, or all their value in one day. Do not count on this strategy to
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save you from losing large sums of money if the stock makes a big drop.Writing covered calls can work. However, you must ﬁnd stocks that meetone of two criteria: trending upward or maintaining a trading range.
As  exhibited  with  XYZ,  covered  calls  work  well  with  stocks  on  therise.  Unfortunately,  even  stocks  with  upward  trends  have  moments  inwhich  they  make  sharp  corrections.  These  periods  are  difﬁcult  for  cov-ered call writers as they watch their accounts shrink, because the coveredcall does not offer comprehensive protection to the downside. However,in  many  cases  good  stocks  will  rebound.  If  you  do  choose  to  write  cov-ered calls, do so only in high-grade stocks that have been in a consistentuptrend and have exhibited strong growth in earnings per share.
To protect yourself from severe down moves, you can combine cov-ered calls with buying puts for protection. If you purchase long-term puts(over six months), you can continue to write calls month after month, butyou will have the added protection of the right to sell the underlying stockat a speciﬁc price.
Exiting the Position
Since a covered call protects only a stock within a speciﬁc range, it is vi-tal to monitor the daily price movement of the underlying stock. Let’s in-vestigate  optimal  exit  strategies  for  the  ﬁrst  covered  call  example,  thesale of the 50 call.
• XYZ rises above the short strike (50): The short call is assigned.Use the 100 shares from the original long stock position to satisfy yourobligation  to  deliver  100  shares  of  XYZ  to  the  option  holder  at  $50  ashare. This scenario allows you to take in the maximum proﬁt of $375.• XYZ falls below the short strike (50), but stays above the ini-tial stock price (49): The short call expires worthless and you get tokeep  the  premium  ($275)  received.  No  losses  have  occurred  on  thelong stock position and you can place another covered call to offsetthe risk on the long stock position if you wish.
• XYZ  falls  below  the  initial  stock  price  (49),  but  stays  abovethe breakeven (46.25): The long stock position starts to lose money,but this loss is offset by the credit received from the short call. If XYZstays above 46.25, the position will break even or make a small proﬁt.• XYZ  falls  below  the  breakeven  (46.25): Let the short option ex-pire worthless and use the credit received to partially hedge the losson the long stock position.
Covered calls are one of the most popular option strategies used intoday’s  markets.  If  you  want  to  gain  additional  income  on  a  long  stock
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THE OPTIONS COURSE
Strategy: Buy the underlying security and sell an OTM call option.
Market Opportunity: Look for a bullish to neutral market where a slowrise in the price of the underlying is anticipated with little risk of decline.
Maximum  Risk: Limited  to  the  downside  below  the  breakeven  as  thestock falls to zero.
Maximum Proﬁt: Limited to the credit received from the short call option+ (short call strike price – price of long underlying asset) × 100.
Breakeven: Price  of  the  underlying  asset  at  trade  initiation  –  short  callpremium.
Margin: Amount subject to broker’s discretion.
position, you can sell a slightly OTM call every month. The risk lies in thestrategy’s  limited  ability  to  protect  the  underlying  stock  from  majormoves down and the potential loss of future proﬁts on the stock abovethe  strike