Gain Investor Insight Through Examples

September 16, 2008
Mark D.Wolfinger

Physician's Money Digest, February28 2003, Volume 10, Issue 4

From the time we first open our eyes,we learn many of life's lessons byexample. Though the harder lessons areusually learned through firsthand experience,teaching by example is an effectiveinstruction method. And in this case,it's a safe way to illustrate market techniquewithout actually participating inthe market and tempting "loser's fate."So, let's stretch our imaginations as wetake a look at the advantages a covered-callinvestment strategy has over a buy-and-hold strategy.

INVESTOR MAKE-BELIEVE

Let's say you bought 100 shares of XYZstock for $40. You then went ahead andsold 1 call option, which allows the buyerto purchase your stock for $40 per shareand which will expire in 6 months. Inreturn for selling the call option, youreceived $600. Now let's fast-forward timeand skip ahead 6 months to the afternoonwhen the option expires. After speakingwith your broker, you find out that theowner of the option is not going to pay$40 for your stock.

Is this bad news for you? Actually, no,it is not. His refusal to buy the stock isnot your concern. Your concern is that noone is going to exercise the call, and thecall is going to expire worthless. However,you're now no longer under anyobligation to sell the stock for $40 andthe option is no longer a valid contract—surprisingly, good results. Sure, you'renot pleased that your stock has declinedin price, but you've managed a profit of$600 because you sold the call option inthe first place.

Think about it:

If the stock is still higherthan $34 (ie, your net cost), you have aprofit. And if your investment shows aloss, that loss is $600 less than the loss youwould have experienced had you used thebuy-and-hold method. You'll have a profitanytime the stock is over $34 (ie, yourreduced cost). For the buy-and-holdinvestor to earn a profit, however, thestock must be over $40. Since the stockwill probably be $34 or higher when expirationday arrives, the covered-call writingstrategy is more likely to show a profitthan the standard buy-and-hold strategy.

ANOTHER CASE IN POINT

Using the same example, let's say thestock stayed at $40. And this time youactually did sell your stock. In this caseyou'll have a 6-month profit of 17.6%—another good result. And since the stock is$40, you may decide to buy it again. If youdo, you are in a position to either sellanother call option or revert to the buy-and-hold strategy. Alternatively, you canuse the proceeds from the sale of thestock to make a different investment andwrite a call against the new stock.

Even if the owner of the option hadn'tbought your stock, however, you stillwould have decent results. In addition tothe $600 you earned from selling the calloption, you still own the stock. This putsyou in the position to sell another calloption or simply hold your stock. Again,whether the option owner buys yourstock or not, the covered-call writing strategyis superior to the buy-and-hold strategyin these 2 scenarios.

The answer:

So why aren't all physician-investorstaking advantage of this investmentstrategy? Besides risk, thereare situations in which you will do betterby not selling the call. However, sellingcovered calls (ie, covered-call writing)instead of simply holding stock (ie, buyand hold) is a strategy that makes moneymore often and loses money less often.In addition, the covered-call strategyalways performs better if the stockdeclines in price.

Mark D. Wolfinger, author of

The Short Book on Options: A

Conservative Strategy for the Buy

and Hold Investor, is an educator

of public investors. He was a

professional options trader at

the Chicago Board Options Exchange for over

20 years. He welcomes questions or comments

at mark@mdwoptions.com. For more

information visit www.mdwoptions.com.