Boosting Your Income with Options

Going naked in public is a risky business. There are legal consequences to consider, but the hysterical laughter of onlookers is a more likely, and more painful, punishment. Going naked with stock options is risky business as well. If stock prices don't go your way, you could lose your shirt. As it turns out, a mellower version of the option--the covered call--not only is less risky but also can help you earn more current income than the most generous savings account. This higher level of income isn't a slam dunk. Unlike savings accounts, which pay a published interest rate whether you're watching your money or not, earning income with covered calls requires some knowledge and effort on your part. The better you understand covered calls as income investments, the more likely you will be pleased with your results. Read on to learn how to put this strategy to work for you.

What Are Options?

Options take some getting used to, so let's start at the beginning. To most people, an option doesn't represent owning something tangible, such as an acre of land. An option is a contract--so what do you actually get for your money when you buy one? The right to buy or sell an asset such as shares of stock at a specific price for a specific length of time. From the option buyer's perspective, options are aptly named. Owning an option actually represents the option to buy or sell an asset. You can choose to pass on your right to buy or sell the underlying stock if the transaction isn't in your financial interest. The contract terminates on the option expiration date. On the other hand, the option seller has a contractual obligation to the buyer, regardless of whether the transaction is advantageous. When you own a call option, the option seller must sell the underlying stock shares to you if you decide to buy them. Owning a put option, you have the right to sell shares of stock at a specific price, so the option seller must buy the stock shares from you.

Suppose you want to buy stock in Lemur Leisure Lines (ticker LEML), a startup company that caters to vacationers who want to bring their pet lemurs along. Unfortunately, you won't have enough cash to buy the shares until your great-aunt pays you for lemur-sitting over the holidays and you're certain that the stock price is going to shoot up as the winter high season starts. Buying a call option is one way out of this predicament. Lemur Leisure Lines stock currently is selling for $18 per share. You don't want to pay more than $20 per share, but you can't afford to buy the stock until January, a month from now. Buying a LEML January $20 call option gives you the right to buy 100 shares of the LEML stock at $20 a share until the option expires--for the purposes of this example--on January 22. If the call option is selling for 75 cents a share, you pay $75 for the flexibility to postpone your purchase of 100 shares of LEML. Let's see how this call option plays out under different circumstances:

• LEML fulfills your expectations and shoots up to $26 a share in January. In this case, you exercise your call option and buy 100 shares of LEML from the option seller at $20 a share. Your total cost is $20.21 a share, including the per-share cost of the call option. You could turn around and sell the stock for $26 a share.

• The lemur leisure market hibernates and the stock price drops to $15. It would be financially silly to pay $20 a share for a stock that is currently selling at $15 a share. In this case, you let the call option expire and purchase your shares on the open market at $15. Your total cost is $15.75 a share, including the per-share option price.

The bottom line: you pay an extra $75 to lock in the maximum stock price for a month.

Before moving on, you should learn how to speak "optionese." Here is the terminology you'll run across if you decide to work with options.

Premium--The price of the option per share of underlying stock. One option contract represents the right to buy or sell 100 shares of stock, so an option premium of $.75 results in a total option price of $75.

Strike price--The price at which the underlying stock is bought or sold. In the LEML example, it's $20.

Expiration date--Options expire on the third Friday of the option month. For example, January '05 options expire January 22, 2005.

Write an option--Sell an option to a buyer.

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Exercise an option--When the option owner chooses to enforce the terms of the option contract to buy or sell the underlying shares of stock.

Being assigned--The option exchange selects an option seller to fulfill the purchase or sale of an option that an owner exercised.

Option names--Option names follow the format <Stock ticker> <Expiration month> <Strike price> <Call or Put> @ <Premium price>. LEML January 20 Call @ $.75 means a call option for Lemur Leisure Lines stock at $20 a share with a premium per share of $.75.

Why Are Naked Options Risky?

A naked call option means that someone writes a call option without owning the underlying stock. If the stock price stays the same or drops lower and the option expires unexercised, the option writer earns the option premium without outlaying any money. Money coming in without any money going out is an infinite return on investment.

Before you race out to sell naked call options, consider that the downside can be as spectacularly bad as the upside is good. If the underlying stock price exceeds the strike price, the option buyer exercises the option and buys the shares of stock from the option seller. Without owning the underlying stock, the naked option seller has to buy shares at the market price, regardless of how high, in order to turn right around and sell them at the strike price.

Suppose you wrote the LEML January $20 call option naked. You earn $75 in call premium. When the buyer exercises the option with LEML at $26 a share, you must buy 100 shares of LEML at $26 a share plus broker commission and sell the shares for $20. Let's see: 100 shares at $26 a share is $2,600 you must pay out. But, you bring in only $2,075 from the call option premium and the sales of the stock shares. That's a 25 percent loss in a month. Theoretically, your potential loss is unlimited if the underlying stock spikes to hundreds of dollars per share the way Qualcomm did back before the tech stock bubble burst. And of course, if you don't have enough cash to buy the underlying shares to make good on your option contract, your broker will institute margin calls and start liquidating your other holdings.

Covered Call Options Reduce Downside Risk

Writing covered call options carries a completely different risk profile than writing naked call options does. A covered call is an option that you write against shares that you purchase or already own. The amount of money you make when the buyer exercises the call option depends on the price you pay for the underlying shares of stock. The risk in selling covered call options is that the stock price might drop below your purchase price, resulting in a loss. Writing covered call options on stock you own actually reduces the risk from a price drop. The premium for the covered call option is income related to the stock, which offsets some of your loss. The graph in Figure 1 compares the loss profiles for owning a stock and writing a covered call option against the same stock. Your break-even price for a stock by itself is your purchase price--$18 in the example in Figure 1. As the figure shows, the $.75 premium per share from selling the covered call reduces your break-even price to $17.25.

Figure 1. The premium you earn by selling a covered call option reduces your break-even price for a stock that you own.

Another significant point illustrated in the figure is that covered call options limit your profit when the share price increases beyond the strike price. Because you receive the strike price for your shares, your profit in a covered call is limited to the option premium plus the profit obtained by selling the shares at the strike price. For this reason, covered calls are more appropriate when the stock market is moving sideways, not increasing quickly such as during a recovery.

Generating Income with Covered Call Options

Both option premiums and the capital gains generated when covered call options are exercised produce current income. You can enhance the income you earn by buying the right kinds of stocks at the right prices and also by selling your covered call options under the right circumstances. Covered call options are a riskier approach to generating income than savings accounts are, but with careful planning you can minimize the risks.

Unlike a savings account, in which your first $100,000 is insured against loss by the Federal Deposit Insurance Corporation, you receive no guarantee that a stock price will behave as you want it to. For example, if the stock price drops and doesn't recover, selling your stock at a loss takes a bite out of your principal. You can reduce the risk of price drops in two ways:

• Purchase solid growth companies with good prospects for the future. Sure, even those stocks can drop in price, but their underlying growth usually pushes the price back up quickly.

• Buy your shares at attractive prices. Stock prices fluctuate for lots of reasons, many of which are no more than overreactions to events. Purchasing your stock on price dips means more capital gains when the call options are exercised.

The income you generate from covered calls depends on what happens to the price of the underlying shares of stock.

• The stock price stays below the call option strike price. The option premium is your only income in this case, but you still own the stock and can write more covered call options on the shares in the future. For the LEML example, if the price remains below $20, the $75 in premiums on your original $1,800 investment equals a 4 percent increase in approximately a month.

• The stock price increases above the strike price. When the call options that you sell are exercised, your income includes the option premium and the capital gain on the stock shares you sell. Using the LEML January 20 call options as an example, you would earn $75 for the option premium and $200 from the gain on the 100 shares (the $20 strike price minus the $18 purchase price, or $2 per share), which is a return of 15 percent.

• The stock price drops. As long as you're confident that the stock will rebound, wait until the price increases above your original purchase price before writing your call options. However, if your opinion of the stock has changed for the worse, you should sell the stock before the price drops even more.