37 lines
2.9 KiB
Plaintext
37 lines
2.9 KiB
Plaintext
Chapter 2: Covered Call Writing 47
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basis. If the write were done in a margin account, the return would be considerably
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higher.
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Note that we have ignored dividends paid by the underlying stock and commis
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sion charges, factors that are discussed in detail in the next section. Also, one should
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be aware that if he is looking at an annualized return from a covered write, there is
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no guarantee that such a return could actually be obtained. All that is certain is that
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the writer could make 8% in 9 months. There is no guarantee that 9 months from
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now, when the call expires, there will be an equivalent position to establish that will
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extend the same return for the remainder of the annualization period. Annual returns
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should be used only for comparative purposes between covered writes.
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The writer has a position that has an annualized return (for comparative pur
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poses) of over 10% and 8 points of downside protection. Thus, the total position is an
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investment that will not lose money unless XYZ common stock falls by more than 8
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points, or about 18%; and is an investment that could return the equivalent of 10%
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annually should XYZ common stock rise, remain the same, or fall by 5 points (to 40).
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This is a conservative position. Even if XYZ itself is not a conservative stock, the
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action of writing this option has made the total position a conservative one. The only
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factor that might detract from the conservative nature of the total position would be
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if XYZ were so volatile that it could easily fall more than 8 points in 9 months.
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In a strategic sense, the total position described above is better and more con
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servative than one in which a writer buys a conservative stock -yielding perhaps 6 or
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7% - and writes an out-of-the-money call for a minimal premium. If this conserva
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tive stock were to fall in price, the writer would be in danger of being in a loss situa
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tion, because here the option is not providing anything more than the most minimal
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downside protection. As was described earlier, a high-yielding, low-volatility stock
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will not have much time premium in its in-the-money options, so that one cannot
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effectively establish an in-the-money write on such a "conservative" stock.
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COMPUTING RETURN ON INVESTMENT
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Now that the reader has some general feeling for covered call writing, it is time to
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discuss the specifics of computing return on investment. One should always know
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exactly what his potential returns are, including all costs, when he establishes a cov
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ered writing position. Once the procedure for computing returns is clear, one can
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more logically decide which covered writes are the most attractive.
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There are three basic elements of a covered write that should be computed
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before entering into the position. The first is the return if exercised. This is the return
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on investment that one would achieve if the stock were called away. For an out-of-the- |