Covered call writers get paid cash when selling call options. Call buyers pay cash to own the options. This article will highlight the reasons options are bought and sold as it relates to covered call writing. We will use a real-life example with CarMax, Inc. (NYSE: KMX), a stock on our Premium Stock Report on October 30, 2019.
KMX option chain on October 30, 2019 with KMX priced at $95.35
KMX calculations with The Ellman Calculator
When the trade is executed, an initial 1-month time-value return of 2.5% is generated with an additional potential 0.7% of upside potential for a possible 3.2% 1-month return. Now, let’s look at this trade from buyers and sellers perspectives.
Option buyers have rights
The option buyer is now controlling 100 shares of KMX per-contract until the 11/29/2019 expiration at a cost of $240.00. The cost of buying 100 shares would be $9,535.00. The buyer has the right, but not the obligation, to buy 100 shares of KMX (per-contract) at $96.00. This makes the breakeven at $98.40. ($96.00 + $2.40). The buyer can:
- Sell the option
- Exercise the option (buy shares)
- Allow the option to expire worthless
Approximately 70% of options are closed, 20% expire worthless and 10% are exercised.
Option sellers have obligations
As option sellers, we are required to provide shares to the option buyers (if they choose to exercise the options) at the strike price and by the expiration. By first buying the shares, we are in a “covered” or protected position… we know our cost-basis. By undertaking this obligation, we are paid a cash premium. The seller can:
- Buy back (close) the short call (buy-to-close) and end the contract obligation
- Allow the contract to reach expiration to expire worthless (if strike ends out-of-the-money) or result in exercise (if the strike expires in-the-money)
Discussion
Option buyers pay for the right to control shares of stock (or ETFs) at a relatively low cost. If they are directionally correct, there is an opportunity to generate impressive returns on the capital investment. Generally, this is a more aggressive approach to option trading than covered call writing.
Option sellers are paid to make shares available to call option buyers. We select the price we are willing to sell our shares for and the length of the contract duration. Generally, this is a more conservative approach to option trading.
Your generous testimonials
Over the years, the BCI community has been incredibly gracious by sending our BCI team email testimonials sharing stories as to what our educational content has meant to their families. Moving forward, we have decided to share some of these testimonials in our blog articles. We will never use a last name unless given permission:
Hi Alan,
Your Complete Encyclopedia is a gem and introduced me to the world of options from simple stock trading. I’m looking forward to a long-term association. I really love your passion and can relate to you as a self-taught in this interesting finance world.
Thanks,
Ankur
Upcoming event
1. Michigan AAII Chapter webinar
Trading in a Low Interest-Rate Environment
Creating a 3-income stream strategy
Wednesday June 24thth
7 PM
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2. Greensboro North Carolina AAII Chapter webinar
Covered Call Writing to Generate Monthly Cash-Flow
Option Basics and Practical Application
Saturday June 20, 2020
10 AM
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This presentation will include the basics of trading option, an overview of covered call writing and 4 practical applications of the strategy.
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Market tone data is now located on page 1 of our premium member stock reports and page 8 of our mid-week ETF reports.
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