Futures & Options: Covered Calls

Purchasing shares of stock in a company while simultaneously selling call options on the same stock is a type of transaction known as a "covered call." The purchasing of covered calls is a reliable and relatively conservative approach to investing, because: (1) if the stock is called away, the investor realizes a profit immediately, (2) if the stock is not called away (i.e. the option expires worthless), but remains close to the strike price, the investor can sell more options on the stock - thus making additional profit, and (3) if there is a downturn in the market, resulting in the stock going down significantly in price, the investor is either completely or partially protected as a result of the monies made through the sale of the options.

Initially, a computerized system performs the following functions after market close each business day:

1. Selects a limited number of stocks subject to the criterion that each last traded with a price near the strike price of a call option that closed with a very high premium

2. For each of the stocks selected above, computes a projected annual return

The computer uses the following formula to calculate the projected annual return:

R = (12 / N) x ((S - C + P) / (C - P))

Where:

R is the projected annual return

N is the number of months until the call expires

S is the strike price of the stock

C is the sum total of the cost of the stock, the commission on the purchase of the stock and the commission on the sale of the stock if it is called away

P is the premium value of the call option less the commission on the sale of the option

Note that taxes are not included in the formula; it is left to the reader to make his or her own tax computations to adjust the projected annual return appropriately.

The computerized system selects stocks and ranks then using strictly technical criteria, i.e., there is no fundamental evaluation of the stocks performed by the computer

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