earning a profit.
Why Writing in-the-Money Calls Produces Frequent Profits
When you own shares of stock, in order to earn a profit, the stock must in-crease in value. When you own any covered call position, to earn a profit,the stock must be above the downside break-even point when expirationday arrives. The lower the break-even point, the greater the likelihood thatthe stock is above that price on any given date. Here’s why.
Let’s consider two different stock prices, one lower than the other. Everytime the stock is above the higher price, it is also above the lower price. Butsome of the time the stock is between the two prices. Therefore, the stock isabove the lower price more often. If those two prices represent break-evenpoints, then the stock is above the lower break-even point more often, andthe investor with the lower break-even point earns a profit more often.
From this we can conclude two things:
1. Any  covered  call  position  is  more  likely  to  be  profitable  when  com-pared with buying and holding stock without writing covered calls be-cause the break-even point is lower.
2. Writing in-the-money options reduces the break-even point more thanwriting at-the-money or out-of-the-money options (the option premiumis higher) and produces profits more often.
More Likely Profits and Additional Safety?
Writing in-the-money options provides increased protection against loss.5 Ifthis strategy reduces risk by providing more downside insurance, and if itproduces more frequent profits, what’s the catch?
In return for the benefits associated with writing in-the-money call op-tions, some of your profit potential is reduced. Thus, choosing which optionto write depends on your personal investment objectives. It’s important toselect a strategy that makes you comfortable and meets your objectives.
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This point is discussed further in Part IV, when we get to the specifics ofwriting covered calls on exchange traded funds.
Writing in-the-money call options enables you to earn a good profit, andthat profit comes with the bonus of owning a safer position. Use this strat-egy whenever you believe that earning a larger profit is less important thanreducing the chances of losing money.
Example
You buy 500 shares of BCD, paying $32.50 per share.
You write 5 Sep 30 calls (expiring in one month) and receive $330 foreach.
Downside break-even point: $29.20 (32.50 – 3.30)
Maximum profit (per 100 shares): $80 (cost = 29.20; sell at 30)
Do I Really Want to Sell Stock for Less than I Paid?
Does it seem strange to buy stock at $32.50 and immediately sell someoneelse the right to buy that same stock from you at only $30 per share? Relax.That’s not what you are doing. Here’s why.
You can look at this situation in two different ways:
1. Use the premium received from writing the call option to reduce yourcost. Thus, you are paying only (in this example) $29.20 per share ofstock, not $32.50. When you sell the stock at $30, you have a profit of$0.80 per share.
2. When you write an in-the-money option, the premium you receive canbe divided into two parts: the intrinsic value and the time premium. Theintrinsic value is a refund of part of your purchase price and the timepremium represents your potential profit.
In this example, the intrinsic value of the option is $2.50 per share(stock price minus strike price) and the time premium is $80. Thus, youcan think of this as a situation in which you pay $32.50 for stock and re-ceive a rebate of $2.50, making your net purchase price $30. The $80time premium represents your profit potential.
Expiration Possibilities
When expiration day arrives, there are two possibilities:
Scenario  1 BCD  is  below  the  strike  price,  and  the  options  expireworthless.  By  writing  the  calls,  you  are  better  off  (by  the  $1,650  you
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collected  from  the  option  sale)  compared  with  the  investor  who  simply holds the stock. That investor has a loss, but you have a profit if the stockis  above  the  break-even  point  ($29.20).  Even  if  the  stock  is  below  thatprice,  your  loss  is  reduced  by  $3.30  per  share  because  you  had  the foresight  to  write  the  call  options.  This  may  not  be  a  profitable  trade for you, but it is a satisfactory result considering how much the stock hasdeclined.
Scenario 2 BCD is above the strike price, and you are assigned an ex-ercise notice. This is your best result. You earn the maximum profit ($0.80per share) attainable when using this strategy. Your return is 2.7 percent forone month, or 32.9 percent annualized.6 This maximum reward is far lessthan that available from writing out-of-the-money call options, but it comeswith a much greater amount of protection against loss. This book will helpyou to choose among the possibilities to find a combination of risk and re-ward that is comfortable for you.
STRATEGY 3: WRITING AT- OR NEAR-THE-MONEY CALLS
Writing at-the-money calls is an attractive compromise strategy and is suit-able for investors who want to earn a good profit and gain a small amountof downside protection. Typically, investors who have a neutral outlook onthe market write at-the-money options. These options have a greater timepremium in their price than either in- or out-of-the-money options. Thus,the potential profit to be derived from the option sale is greatest for at-the-money options.7 The potential for profit based on stock price movement isgreater when selling out-of-the-money options.
At-the-money options are priced lower than in-the-money options buthigher  than  out-of-the-money  options.  Thus,  they  afford  the  covered  callwriter an intermediate amount of protection to the downside.
Example
You buy 500 shares of BCD at $32.50.You write 5 BCD Sep 321⁄2 calls (expiring in one month) and receive$180 for each.
Downside break-even: $30.70 (32.50 – 1.80)
Maximum profit per 100 shares: $180
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Expiration Possibilities
Scenario 1 BCD is below the strike price, and the options expire worth-less.  This  is  a  satisfactory  result.  Once  again,  you  are  better  off  by  theamount  you  received  for  writing  the  calls  than  the  investor  who  simplyowns stock.
Scenario 2 BCD is above the strike price, and you are assigned on yourcall options. You earn the maximum possible profit from this position, or$900 (180 times 5) on an investment of $15,350 for a return of 5.9 percent(70.4 percent annualized).
STRATEGY 4: WRITING OPTIONS WITHMORE DISTANT EXPIRATION DATES
This strategy is more conservative than writing options with shorter expi-rations because you receive a higher option premium, affording a greateramount of protection to the downside. Remember, options with more timeremaining until expiration are worth more and trade for higher prices thanshorter-term options. You can combine this technique with writing eitherin-the-money, at-the-money, or out-of-the-money options.
As a general guideline, the time premium in the price of an option is re-lated to the square root of the time remaining until the option expires. Sim-ply, this means that an option with four months until expiration often hastwice the time premium of an option with one month remaining. A nine-month option contains roughly three times as much time premium as a one-month  option.  Because  other  factors  come  into  play  in  determining  theprice of an option, this is merely a reasonable estimate.8
As  with  other  covered  call  writing  strategies,  when  safety  increases,some profit potential must be sacrificed. Options with more distant expira-tion  dates  provide  a  greater  potential  profit  per  option—but  provide  asmaller potential profit on an annualized basis. The next examples illustratethis  point.  Because  most  discussions  concerning  portfolio  returns  arebased on annualized earnings, it’s important to be aware of the annualizedprofit potential for each of your covered call positions.
Assume you buy 500 shares of BCD, paying $32.50 per share.
In-the-Money Example
You  write  5  BCD  Dec  30  calls  (expiring  in  four  months)  and  receive$500 for each.
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Downside break-even point: $27.50 (32.50 – 5)
Maximum profit (per 100 shares): $250 (cost = 27.50; sell at 30)
At-the-Money Example
You write 5 BCD Dec 321⁄2 calls and receive $370 for each.Downside break-even point: $28.80 (32.50 – 3.70)
Maximum profit (per 100 shares): $370
Out-of-the-Money Example 1
You write 5 BCD Dec 35 calls and receive $280 for each.
Downside break even point: $29.70
Maximum profit (per 100 shares): $530
Out-of-the-Money Example 2
You write 5 BCD Mar 35 calls (expiring in seven months) and receive$400 for each.
Downside break-even point: $28.50
Maximum Profit (per 100 shares): $650
Scenario 1 The options expire worthless. In each case, if the stock isabove the downside break-even point, you earn a profit. As always, whenthe stock declines in price, you are better off than an investor who does notwrite covered call options.
Scenario 2 If assigned an exercise notice on your calls, you achieve themaximum possible profit from the position.
Summarizing the examples used in this chapter, the data in Table 10.1 com-pare  the  results  of  writing  longer-term  options  with  writing  shorter-termoptions. Because so many variables come into play when determining theprice  of  an  option  in  the  marketplace,  you  cannot  predict  what  optionprices will be available when you are ready to write a covered call. But youcan use the data from the table to get a feel for how the profit potential isaltered when you change from writing near-term options to writing optionswith longer expirations. Of course, don’t expect to find these exact samplereturns duplicated in the real world.
The data presented in Table 10.1 illustrate some points that are impor-
tant for you, as a potential option writer, to understand.
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Time Value and Profit Potential
(Reminder: Time Value = Option Premium – Intrinsic Value)
• The time value of an option increases as time to expiration increases.• The time value of an option is greatest for at-the-money options.• The time value of an option represents your maximum potential profit
from the option part of a covered call position.
Protection (Insurance against Loss)
• The  lower  the  strike  price  of  a  call  option,  the  lower  the  downside
break-even point and, thus, the more protection against loss.
• The  more  time  remaining  until  the  option  expires,  the  greater  the
amount of downside protection.
• Increased protection comes at the expense of lower annualized profit
potential.
Annualized Profits
• As the time to expiration increases, the maximum dollar amount you
can earn from a covered call position increases.
• As the time to expiration increases, the maximum annualized return on
your investment decreases.
• As the strike price of the call option increases (and becomes an out-of-the-money  option),  the  greater  the  amount  of  potential  profit.  Ofcourse, that increased profit potential is derived from a hoped-for in-crease in the price of the underlying stock and is not directly related towriting the call option.
It’s a good idea to examine bid-ask options data online.9 Doing so al-lows you to get familiar with option pricing and practice calculating the po-tential  profit  for  a  myriad  of  possible  covered  call  positions.  Gainingexperience with the calculations before you begin trading makes you betterprepared when you enter your first option order.
NOTE TO NONBELIEVERS
If you are an investor who doesn’t accept the premise that it’s extremelydifficult for an individual investor to outperform the market (see Part I),and if you still believe the correct strategy is to build a portfolio of individ-ual stocks, you still can profit from a thorough understanding of coveredcall  writing.  It’s  a  strategy  that  you  can  use  to  enhance  your  investmentreturns. By all means, continue to select your own investments, but seri-
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ously consider writing out-of-the-money options. That method allows youto  continue  to  rack  up  capital  gains  from  your  own  stock  picks—if  youtruly  are  a  successful  stock  picker—and  at  the  same  time  collect  optionpremiums to add to your earnings. If you are wrong and your stocks don’tperform  as  anticipated,  the  option  premium  you  earn  will  be  a  welcomeconsolation.
Can You Make Enough Money to Bother Writing Covered Calls?
When adopting more conservative strategies, the potential profits may ap-pear  to  be  anything  but  spectacular.  Most  books  touting  an  investmentmethodology  claim  extraordinary  profit  potential  to  lure  readers  intoadopting suggested methods. That is not the method here. The money youcan earn writing covered calls is limited, but it’s still possible to earn ex-traordinary returns. This book illustrates an investment method that pro-vides ample returns and still reduces the risk of owning investments in thestock market.
Yet if your objective is to double your money every year, you have thechance to achieve that goal by buying stocks that undergo substantial priceincreases and by  writing  out-of-the-money  calls.  Doing  so  allows  you  tocapture a good portion of those capital gains as well as to collect optionpremiums. Of course, finding those great stocks to buy may present a prob-lem.
Some investors may find the potential profits cited in Table 10.1 to betoo small to be worth the effort involved in adopting a covered call writingstrategy. To those investors, I offer two comments:
1. If you earn “only” 2 percent per month on a consistent basis, and if youallow the money to remain in the account and compound, your moneydoubles  every  three  years.  (Earning  2.0  percent  per  month  for  36months turns $1,000 into $2,040.) This return is not only substantiallybetter than the historical stock market return of approximately 11 per-cent per year, but this method makes it more likely you will outperformthe market averages on a consistent basis.
2. In  today’s  investment  world,  the  premium  level  of  listed  options  islower than it has been through much of options’ history. Although op-tion premiums may decrease further, it’s reasonable to expect they willbe higher, on average, in the coming years. (See Chapter 12 for an ex-amination of historical option premium levels.) If that’s true, then re-turns available from writing covered call options will increase as thosepremiums increase.
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CHOOSING THE CALL TO WRITE: SUMMARY
Table 10.2 summarizes the picture of covered call writing from the point ofview of selecting an option to write. Usually each investor chooses an op-tion to write that provides the best combination of profit potential and riskmanagement. To learn which strategy suits you best, write some coveredcalls in the real world, and see if you are comfortable with the positions andif they are helping you meet your investment objectives. I suggest that youbegin with short-term at-the-money options on stocks you already own. Ifyou like the strategy, start building your ETF portfolio and writing coveredcalls on your new investments.
TABLE 10.2 Which Option to Write
Option Description
Strike PriceOut of the moneyAt the moneyIn the money
Time to ExpirationFront 2 monthsFew months 
Profit Potential
Downside Protection
Market Outlook
HighestIntermediateLeast
LeastIntermediateMost
BullishNeutral to bullishNeutral to bearisha
Highest
Least
(3–5 months)
Intermediate
Intermediate
Longer term 
(6–8 months)
Least
Most
Long-term investment
aAll covered call writing strategies are bullish. But if short-term bearish, writing in-the-money calls is a viable alternative to selling stock.
WHAT ARE THE RISKS OF COVERED CALL WRITING?
Although writing covered call options is a more conservative strategy thansimply  buying  and  holding  individual  stock  market  investments,  as  withany  investment  involving  the  stock  market,  it  is  not  risk  free.  There  arefour major risks associated with this strategy.
1. If the stock undergoes a severe price decline, you may lose money. Thepremium  received  from  the  option  sale  provides  some  insuranceagainst loss and reduces any loss, but there is no guarantee against los-ing money.
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Note: If you are an investor who is likely to continue to hold your stockpositions during a market decline, then this is not a risk factor for you.In fact, writing options reduces your losses during the decline.
2. If your primary objective is to sell stock at the strike price, it’s possible
that writing a covered call option will cause you to lose the sale.Here’s how: If the stock price climbs above the strike price during thelifetime of the option and subsequently falls below that price when ex-piration arrives, the call owner does not exercise the option and you donot sell your stock. If instead of writing the call option, you enter a limitorder with your broker to sell the stock, the stock would be sold whenit reaches your price. Thus, by accepting the call premium, you run therisk of still owning the stock after it reaches your target selling price. Ifyou have no interest in selling the stock, then this is not a risk factor for you.
3. If your stock rises through the strike price and advances through yourupside break-even price, you lose the opportunity to sell stock at thehigher price, as writing the call places a cap on your selling price. Youstill  earn  a  good  profit  (some  investors  mistakenly  believe  they  losemoney  in  this  situation),  but  this  profit  is  less  than  you  could  havemade  without  the  option  sale.  However,  keep  this  in  mind:  Most  in-vestors don’t know whether a stock is going to continue to go higher orif it’s about to reverse direction. Most investors sell their positions wellbefore  the  ultimate  high.  Thus,  even  if  you  don’t  write  a  call  option, it doesn’t mean you can earn the maximum profit available from theposition.
4. If you own a dividend-paying stock, it’s possible to fail to collect thedividend. The call owner has the right to exercise the call at any timeand may choose to do so before the stock goes ex-dividend. If that hap-pens, you do not receive the dividend. It’s not all bad news: You sellstock at the strike price earlier than expected (before expiration), andyou can put the money back to work early by reinvesting the proceedsof the sale.
Another risk associated with selling call options is impossible to quan-tify, for it’s a psychological risk. Some investors want the best of all possi-ble worlds every time they make a trade and are never satisfied with less.As you have seen, covered call writing enhances the returns of an invest-ment in the vast majority of the cases. When the stock declines, remains unchanged, or increases by a limited amount, covered call writing allows in-vestors to earn additional profits. The only time it does not improve resultsoccurs when the underlying stock undergoes a substantial price increase.For some investors that’s not good enough. If you fit into this category and
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always must achieve the best possible results, you may have some difficultyadopting a strategy that includes covered call writing.
CONFLICTING INFORMATION?
If you learned about covered call writing elsewhere, it’s likely you’ve beenadvised that this strategy is designed for investors and traders who believethe stocks they own are not likely to advance in price in the near future. It’strue that the best psychological result occurs when the stock holds steadyand the option you write expires worthless. Remember, predicting that astock is not going to increase in value is against the teachings of MPT.
This strategy is suitable for much more than just stable markets, andthe best financial result occurs when you are assigned an exercise notice.Covered call writing provides protection during market downturns and isextremely profitable during bull markets. This strategy is suitable for mostinvestors  who  want  to  own  positions  in  the  stock  market,  regardless  ofmarket conditions.10
Remember that modern portfolio theory teaches us that trying to timethe market is not a winning strategy. Thus, I believe that covered call writ-ing is a suitable investment strategy in any market condition—for that por-tion of your assets allocated to investing in the stock market.
Authors  who  recommend  that  covered  call  writing  be  adopted  onlywhen a stable stock market is expected are speaking to traders rather thanto investors. Traders have a much shorter time horizon and often hold po-sitions for only a few days (or minutes). Although short-term traders canuse covered call writing, this strategy is much more effective for investorsand their longer-term outlooks.11
SUMMARY
When comparing the writing of covered calls with the strategy of simplybuying and holding stocks:
• Writing  calls  allows  you  to  make  money (or  lose  less)  if  your  stock
goes down.
• Writing  calls  allows  you  to  make  more money  if  your  stock  is  un-
changed.
• Writing calls allows you to make more money if your stock increases in
value by a limited amount (up to the upside break-even point).
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• Writing calls earns less money if your stock increases in price beyondthe upside break-even point. You still do well; you still earn good prof-its, but not as much as you could have made without the call sale.
There  is  a  saying  on  Wall  Street  that  sums  up  the  rationale  behindadopting a covered call writing approach to your investments: “Sometimesthe bulls win, sometimes the bears win, but the pigs always lose.” Don’t begreedy. Invest according to the teachings of MPT and allow your enhancedearnings to compound over time. You have a much better chance of beatingthe market with this approach than with attempting to choose your own in-vestments or to put your faith in the professionals who manage traditionalmutual funds.
Each investor must make an individual decision concerning the suit-ability  of  writing  covered  calls,  but  I  strongly  believe  the  rewards  morethan compensate for the risks.
This option writing strategy produces a better result the vast majorityof the time and is an appropriate investment strategy for a great many in-vestors. Yet the possibility of making a killing on any one investment oftenprevents an investor from adopting the covered call writing strategy. If youaccept the precepts of MPT and recognize that it’s exceedingly difficult tooutperform the market on a consistent basis, then adding covered call writ-ing to your investment methods is likely to improve your results. In Part IVwe’ll  discuss  how  you  can  use  this  strategy  when  investing  in  exchangetraded funds.
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C H A P T E R   1 1
Option StrategiesYou Can Use toMake Money
Uncovered Put Writing
Covered call writing and uncovered put writing are very similar strate-
gies. They have identical risk parameters (see Table 11.1) and are dif-ferent  investment  vehicles  for  achieving  the  same  investmentobjectives. Each has its own advantages, and many investors achieve satis-factory results using both strategies.
UNCOVERED PUT WRITING: THE STRATEGY IN A NUTSHELL
The writing of uncovered, or naked, puts is an investment strategy in whichyou enter into an agreement with another party (the option buyer). You ac-cept an obligation, for a limited time, that grants the other party the right toforce you to buy stock at an agreed-on price (strike price). As with coveredcall writing, you have no say in whether (or when) that other person willchoose to exercise the put option and force you to buy the stock. That de-cision  rests  entirely  with  the  put  owner.  Because  the  price  you  can  beforced  to  pay  is  known,  the  most  you  can  lose  is  the  cost  of  the  shares(strike price times the number of shares) minus the option premium youcollect. This maximum loss is similar to (but less than) that of an investorwho owns stock outright.
Uncovered put writing is a bullish strategy, and the profit potential is
limited to the option premium you receive for writing (selling) the put.
100
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TABLE 11.1 Comparing Risk
Covered Call Writing versus Uncovered Put Writing
Covered Call Writing
Uncovered Put Writing
Stock
Buy 100 shares @ 42
None
WriteOption PremiumIntrinsic ValueTime Premium
Cash OutlayCash Backing
Max ProfitMax LossDownside B/E
Advantages/Disadvantages
1 Nov 40 call$3.50$200$150
$3,850 debitNone
$150$3,85038.50
All brokers allowCan’t overspend2 commissionsDifficult to close
1 Nov 40 put$1.50None$150
$150 credit$3,850
$150$3,85038.50
Not always allowedMay sell too many putsOnly 1 commissionEasy to close
The person who buys your put wants the stock price to plunge. If thathappens, the option owner makes a sizable profit by buying stock at a muchlower price in the open market and forcing you to buy that same stock atthe much higher price. That unhappy scenario is probably going to happento you on occasion. Writing uncovered put options is a strategy that can beused  intelligently  to  increase  the