Covered Call Boot Camp
Basic Training in Call Writing
Please note that it is not necessary to learn this information in order to use Jack Adamo’s
Option Income Advisor. The service requires almost no knowledge of option buying or selling on
the part of the subscriber. The following information is provided solely to increase your understanding of the process.
A Call Option (also known simply as a "call") – is an agreement that allows one investor to BUY
a stock from another investor (the option seller, or option writer) at an agreed-upon price, any
time during a specified period. The buyer of a call option pays the seller of the option
for this right. That fee is called the option premium. The operation of buying stocks and
selling options on them is also called writing covered calls or doing a Buy/Write. There is a lot
of strategy involved in picking the right stocks to write calls on, but at Jack Adamo’s Option
Income Advisor, we take care of all that for you.
Exchange-traded call options are sold with expiration dates in 3 month increments,
up to one year out in most cases. The expiration date is the date when the option buyer
loses the right to exercise his option to buy your stock. If he does not exercise it, the owner
keeps the stock, and pockets the option premium. In many cases, as the stock owner, we then sell
another option on the same stock.
Alternately, if the option owner does exercise the option, he buys the stock from you at the
predetermined price called the strike price. You still keep the option premium. Whether or not
the option is exercised, you keep any dividends declared before the option is exercised. This
can add some extra option income.
Options are typically sold with strike prices or "strikes" in increments of $1 or $2.50.
Cisco Systems’ stock, for example, might be selling for $24 per share on a given day,
and at that time there will usually be options available to buy the stock for $20, 22.50, $25,
$27.50 and other prices. There will also be various expiration dates on these options.
All else being equal, options that have longer terms to expiration sell for higher prices
than those with shorter terms because they allow more time for the stock to move.
"What the option buyer is doing is like playing a slot machine, and we are 'the house'."
A Simple Example
Say you, the option writer, buy shares of XYZ Corporation (with the sole intent of optioning the
stock, as is our strategy) at $18 and you write an option that expires 6 months from now at a strike
price of $19. Let us further assume the premium you receive is $1.40 per share.
We’ll go into the math of your profit later, but first, let’s examine what happened here.
Q. Why did the buyer take an option to buy stock at $1 above the price he could buy it for in the open market today?
A. He did so because for $1.40 per share, he has the ability to option stock that would
cost him $18 to purchase. To him, that lower upfront capital investment means he can have a chance
to make money on more shares of stock than he could if he simply bought the stock outright. He’s
willing to wager that he will be correct about the stock’s movement within the limited time allotted
by the option. If the stock goes above the $19 strike price, he will probably exercise the call, but
it has to go up to at least $20.40 before he makes any money. That’s because of the extra $1.40 premium he
paid for the option. At $20.40 he’ll be able to exercise his right to buy the stock at $19, then he can turn
around and sell the stock for a profit at the current market price. But really, option buyers are hoping
the stock goes much higher than this. Otherwise, it would make no sense to take the risk of losing
all his money if the option expired before reaching a profitable level.
"But as the house, we have the statistical edge, and in the long run,
that pays off for us in a good, steady income."
An option buyer is a gambler. He is hoping for returns that defy statistical probability. He is not
thinking about the studies that show that most of the time he will simply lose money. He’s looking for
that big payoff, the double zero on the roulette wheel, or the three cherries on the slot machine. In fact, that
is probably the best analogy. What the option buyer is doing is like playing a slot machine, and we are
"the house." To the gambler, the fact that he wins once in a while validates his belief that he can win.
But as the house, we have the statistical edge, and in the long run, that pays off for us in a good, steady income.
Those are the basic facts about writing calls, but if you want to explore some of the nuances of
different strategies we use, or compare potential returns, read the next section.
Next: Safer Income, Higher Income
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