Let's say, we decide to buy shares of Amati Communications, symbol AMTX at a price of $14.50 a share. If we buy 500 shares the cost will be $7,250.00, but we will buy those 500 shares on MARGIN.
MARGIN: A credit-based loan from your stockbroker, based on the value of the stock you buy. Generally, 50% is the norm. Why would the broker do that? They will sell you more shares and charge you interest on the money loaned to you - usually varying between 7 and 11% per year.
Since we are going to write a Covered Call expiring the next month, this loan will cost us about 1%. However, for the simplicity of the tutorial, commissions and interest will not be included in the calculations.
So, we decide to buy 500 shares of AMTX for a value of $7,250.00. But with leverage of the loan, our cash required is only half of that: $7,250.00 : 50% on margin = $3,625.00.
Now, we are in the month of January and we want to see what the PREMIUM is for the February Covered Call at $15.00 STRIKE PRICE.
PREMIUM: The price the buyer pays us for the option to purchase our stock. (Writing a Covered Call means you sell to someone that option.) The premium for this AMTX option is $1.50. The person paying us the PREMIUM will have the right but not the obligation to exercise (to buy) our shares at the STRIKE PRICE OF $15.00 at or before the expiration date of February 21st.
EXPIRATION DATES are always the third Friday of each month!
STRIKE PRICE: Is the price at which the underlying stock will be sold if the buyer of the option exercises their right to purchase.
When you sell a Covered Call you must know that options, selling or buying, are always written in 100 share contracts. As we sell a Covered Call on AMTX for 500 shares, this equals 5 contracts.
Knowing that, we see that the premium for a share of AMTX for the February $15.00 call can be sold for $1.50:
500 shares x $ 1.50 = $750.00 PREMIUM.
If we want to CALCULATE OUR RETURN, we are going to divide the premium received by the cost of our shares:
PREMIUM: $750.00 divided by Investment: $3,625.00 = 20.68 %
RETURN FROM ONE MONTH TO THE NEXT, OR 248.16 % ANNUALIZED! (less commission and margin interest).
So far, we don't think we have lost you. Let's do a quick review of this exciting strategy:
We have decided to buy 500 shares of Amati Communications at the price of $14.50 a share for an amount of $7,250.00 on margin. Our out of pocket expense was $3,625.00.
We have also decided to write a February Covered Call for a strike price of $15.00.
The Premium for this Call is $ 1.50 a share which amounts to a total of $750.00 Premium paid.
Return Example 1
If from the time we write the Covered Call until its expiration date, the STOCK PRICE REMAINS AT ABOUT THE SAME LEVEL, the option buyer most likely will not exercise his/her option to purchase our stock. After the expiration date we are free to write another covered call for the next month. In this case, WE KEEP THE $750.00 PREMIUM RECEIVED, WHICH EQUALS 20.68 % RETURN.
Return Example 2
If from the time we write the Covered Call until its expiration date, the STOCK PRICE INCREASES IN VALUE TO THE LEVEL OF OR ABOVE THE STRIKE PRICE, the option buyer most likely will exercise his/her option and will buy our stock or part of it at $15.00 a share.
Let's do the math:
We have to sell our 500 shares x 15.00 = $ 7,500.00
As we bought them for $ 14.50 a piece we have an additional gain of $.50 a share.
$.50 x 500 = $ 250.00 + $ 750.00 premium = $ 1,000.00 return.
This situation will increase our return.
$1,000.00 divided by $ 3,625.00 = 27.58%
Return Example 3
If from the time we write the Covered Call until its expiration date, the STOCK PRICE LOSES IN VALUE, the option buyer most likely will not exercise his/her option to purchase our stock. At that point we have a loss on the value of the stock. As an example, if the share drops to $13.00 from $14.50, that loss will be compensated by the premium received. From then on we can either sell another Covered Call on the same stock right away, or we can wait until the stock bounces back before writing a Covered Call at a higher premium. We can also sell the stock and buy another one we like better.
Also, if the decreased value in that stock is not offset by the premium received, your broker may ask you to make up for the difference in the new value of the underlying interest. This request from your broker is a Margin Call.
As a rule, for your own comfort, you should always have a minimum of 20% of your portfolio on margin in your cash account to cover a margin call.