The volatility in the markets has caused pricing for certain derivatives to shoot through the roof, allowing investors to earn huge returns by selling covered calls (also known as writing covered calls).  Here’s an example of a real transaction involving selling covered calls that one of our businesses recently contemplated.

Right now, we could purchase 6,000 shares of U.S. Bancorp for $19 per share for a total investment of $114,000.  We think that long-term, the bank is worth substantially more; it has a strong balance sheet, management ordinarily receives much more money from dividend income than they did salaries and bonuses because they own a lot of stock (giving them a powerful incentive to start paying the dividend again as soon as possible after it was cut during the meltdown), and they have raised money to repay the United States Government TARP money.  We think that over the next 3 to 5 years, it could get back to $30 to $40 per share, which would generate a profit between $66,000 and $126,000 on our position.

However, we know that in the short-term, the stock could fall and experience substantial paper losses.  It isn’t unusual for the banks to fluctuate 20% to 30% in a week.  We are fine with that – we like the underlying business and have the financial capacity to hold it if it does decrease in price.  To help generate income from this holding, we enter into a special type of strategy that results in us writing call options against our stock.  This strategy is often called selling covered calls.

The Mechanics of Selling Covered Calls

With a large enough portfolio, it's possible to generate tens of thousands of dollars per year in cash by selling covered calls on stocks you already own. In essence, you are being paid today for giving up the potential upside tomorrow.

Here’s how it works: After we bought the stock, we go to the Chicago Board of Trade and agree to write (or “sell”) call contract to other investors.  Each call contract covers 100 shares of U.S. Bancorp stock.  These contracts give whoever buys them the right to buy our stock in USB at $19 per share between now and Friday, June 19^th, 2009.  That is only 25 days in the future.  They can exercise their right anytime they choose until that date, at which point the contract expires and is worthless.

In exchange for buying these contracts that we have created, they pay us an insurance premium of $1.10 per share.  For all 6,000 shares, that works out to $6,600.  This money is deposited into our brokerage account immediately and it is ours forever, no matter what happens.  They can never get it back or get a refund.

The 3 Possible Outcomes for Our Selling Covered Calls Position

There are three possible outcomes for our covered calls, depending upon what the stock market does.  They are:

• Possibility 1 – The Stock Stays the Same Price: The stock remains the same price ($19) for the next 25 trading days until June 19^th, 2009 and the options are never exercised, expiring worthless.  (After all – why would the people bother to exercise the contract if they can buy the stock for the same price as they can on the New York Stock Exchange?)  In this case, we continue to own our 6,000 shares that cost us $114,000 but we also have the $6,600 in cash we were paid for the contracts that no longer exist.  In effect, our net cost was $107,400, or $17.90 per share.  Our cost basis was lowered so if the stock falls to $17.90 from $19.00, we are still at breakeven because of the profit on the contracts.  Thus, in the event of a further market crash, we have an additional cushion protecting us.  The day after the contracts expire, we can simply write new ones if we want and earn an additional round of insurance premiums, making even more profit and lowering our cost basis further.

• Possibility 2 – The Stock Price Falls: If the stock price falls to, say, $15.00 per share, then the contracts will be never be exercised (again – why would the owners buy our U.S. Bancorp stock at $19.00 per share when they can just go on the New York Stock Exchange and buy them for $15.00?).  We still have the $6,600 insurance profit and our cost basis on the stock was lowered to $17.90 so our total paper loss currently stands at $2.90 per share ($17.90 adjusted cost basis – $15.00 market value = $2.90 paper loss).  Still, this paper loss of $17,400 ($2.90 per share paper loss x 6,000 shares) is still less than we would have had!  Without the contracts, remember, our cost basis would have been $19.00 per share – not $17.90.  Thus, we would have had paper losses of $24,000.  The contracts we wrote provided us with income that gave us a bigger cushion for when the market fell.  We were better off than we would have been had we just bought the stock and held it. The day after the contracts expire, we can simply write new ones if we want and earn an additional round of insurance premiums, making even more profit and lowering our cost basis further.

• Possibility 3 – The Stock Price Increase: Imagine the banking industry skyrockets and U.S. Bancorp stock goes to $25 a week from now.  Had we just owned the stock and not written these contracts, our position would be worth $150,000 for a gain of $36,000 or $6.00 per share.  We wrote those contracts, however, so the owners are going to force us to sell our stock at $19.00 per share.  (They then take the stock and sell it at $25.00 pocketing the difference between $25.00 and $19.00, or $6.00, less their $1.10 insurance premium they paid us for a profit of $4.90 for every $1.10 they invested so they made out really, really well.)  That means that we bought our stock for $19.00 per share (6,000 shares x $19.00 = $114,000 total) and sold our stock for $19.00 per share (6,000 shares x $19.00 = $114,000) so we broke even on the actual stock.  Remember, though, that we get to keep the insurance money!  That means we $6,600 in cash that is still sitting in our account.  That works out to a 5.789% return for only 25 days ($6,600 profit on insurance contracts divided by $114,000 total capital invested = 5.789% return)!  To put that in perspective, on an annualized basis, it’s like earning 84.5194% per year on your money at a time when you’re lucky to get 1% parking it in the bank.  Given that level of return, we don’t care that we gave up the potential for $36,000 in profit because we had better odds and still made a huge percentage gain.  We take our money and search for the next opportunity.

In other words, we look at it this way: If the stock goes down, we have protection in the form of a lower cost basis.  If the stock remains the same, we have no paper losses and earned a 5.789% return in only 25 days, which works out to 84.5+% per year if you annualize it.  If the stock goes up, we left some big profits on the table but, again, we earned a huge return so why would we complain?  In exchange for giving up the potential for the stock to skyrocket, we locked in a guaranteed return now.

These Call Option Prices Probably Won’t Last Long

The pricing on the bank options cannot exist like this for very long – my guess is perhaps a year at the most.  That’s why we’re doing as much as we can because we don’t believe it will last.  Right now, the markets are driven by the conflicting fear of watching everything plummet or missing out on a huge gain when the economy recovers.  That’s why you can earn such high insurance premiums on contracts.  Between all of our accounts and companies, we’ve made tens of thousands of dollars doing this since March of 2009 by dedicating a portion of our portfolio to the strategy.

Of course, there are advanced ways to do this – I’m just giving you the basics – where you can actually trade the options you’ve sold against your stock and make even more money but that’s too advanced for an introduction.  Right now, we’re going to keep it simple.

The strategy is easy to implement and any broker can help you understand the process.  All you need is a regular stock brokerage account with options trading privileges.  The commissions are low – on a trade of this size, we may pay only $50 by the time it’s over.

A Special Note on the Risks of Selling Covered Calls

(One important note: You must never – and I mean never – sell contracts for stock that you don’t own outright!  Here’s why: If U.S. Bancorp had gone to $40 per share and you didn’t own the actual shares, you are on the hook legally to sell 6,000 shares at $19.00.  Thus, if you don’t have them, you would have to buy 6,000 shares at $40 each so that when the contract holder sends you the $19.00 for your shares, you have the stock to trade them.  That would cost you $240,000 – and you’d have to sell them for $114,000!  Thus, you would have a loss of $126,000 (or $119,400 after backing out the profit you earned on the call contracts you sold).  This extremely risky practice is known as selling “naked” calls because you don’t have the stock sitting in your account.  You are taking on unlimited liability – if the stock went to $100 per share, you’d have to come up with it because you legally owe the people who bought your contracts those 6,000 shares if they choose to exercise the contract!  So, repeat after me: I will never, under any condition, for any reason, sell naked call options.)