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Mention the term strategy, and many investors picture limited upside potential, with the potential for making a small profit. These investors may also consider the real beneficiaries of the strategy to be the sellers of the s who benefit handsomely when the price of the stock increases significantly.
A covered call is a strategy wherein an investor sells a against an existing stock or against a stock purchased specifically for the position. A covered call is similar to purchasing a house and leasing it out with an option to purchase. The person leasing-out the house receives a monthly income, however the person leasing-out the house may lose his income-generating vehicle if the person leasing the house decides to exercise the option for purchasing the house.
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A profit and loss graph for a covered call looks like this:
Just like a landlord leasing out his property, a position can generate monthly income by re-writing or selling s against a stock. For this strategy to work, the needs to expire worthless at options expiration.
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A real-world example will be considered in order to illustrate the concept of re-writing a covered call position.
On 4/27/2009, 's Titanium newsletter published a covered call position for American Express (). At the time, the price of AXP's stock was at $24. 89 and the price of the sold (AXPEE) was $1. 70. Order ismo cod
the had an expiration for may of 2009 with a strike price of $25. Not applying any type of management, the maximum potential return for the AXP covered call was 7. 8%. The maximum potential return of 7. 8% is partially a result of time premium ($1. 70) and appreciation in the price of the AXP stock price ($0. 11).
» return goal > 2% / month
» works in any market
At options expiration on 5/15/2009, the price of AXP closed order ismo cod
at $24. 23, so the May 2009 expired worthless since $24. 23 is less than the strike price of $25 for the . The initial premium of $1. 70 for selling the was retained as profit. The price of AXP was less than at entry by $0. 66, so the total profit generated by the strategy was $1. 70-$0. 66 or $1. 04 which represents a return of $4. 5%, not bad for only 19 days in the investment.
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On 5/18/2009, a new (AXPFE) with expiration in June of 2009 and a strike price of $25 was sold against the existing AXP stock for $2. 10.
At options expiration on 6/19/2009, the price of AXP closed at $24. 64 and the June 2009 expired worthless, as $24. 64 is less than the $25 strike price of the option.
On 6/22/2009, a new (AXPGA) with expiration in July of 2009 and a strike price of $24 was re-written against the AXP stock for $1. 15. The price of AXP was down on 6/22/2009 at a price of $23. 23 which is why the with a $24 strike was sold rather than a with a $25 strike as used previously. The with the $24 strike was selected as it had the most potential return with respect to time-value, the other s for AXP had significantly less potential return.
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At options expiration on 7/17/2009 the price of AXP closed at $28. 03 and since the stock price was greater than the $24 strike price of the , the was exercised and the AXP stock was called away.
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The total return generated by selling the s against AXP was 17. 8% and the total return from simply purchasing AXP and holding it would have been 12. 6%.
|Return Selling Covered Calls Against AXP
||Return with Buy-and-Hold for AXP
By using the strategy, the return generated for AXP was increased significantly over a buy-and-hold strategy.
Additionally, instead of allowing the AXP stock to be called away on 7/17/2009, an investor could optionally have rolled the July 2009 to an August and prevented AXP from being called away. For example on 7/15/2009 when AXP was at a price of $27. 22, the July could have been purchased for $3. 20 and rolled to an August with a strike price of $27 for $2. 00. This new position would have had the potential to add an additional 7% of return to the AXP investment.
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, re-writing, AXP, American Express Co. [/tags] ?? 2008-2016 Legit Express Chemist.