Covered Call Program Example

Overview:
Using covered calls, cash flow is achieved by purchasing common stock for your account and then selling a call option on that stock. A call option gives the buyer of the call option the right to purchase your stock for a predetermined price at a future date. This kind of program is called a "covered call". People purchase options for a price. Your account receives the proceeds from the sale of the option. The proceeds your account receives has two components:

1) real value - the difference calculated by subtracting the option price from the price of the stock, and

2) premium - the additional amount you receive in excess of the real value. The premium is potential gain to your account and lowers your overall risk of owning stock. Your risk is lower than simply owning the stock because if the price of the stock falls below the "strike price", you still keep the proceeds from the sale of the option.

For those interested in more detail please read the example below. This can be confusing to those not familiar with options so we invite you to call us with your questions after you read these pages. Contact Us

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Covered Call Example

To begin this example, we purchase a stock for your account and at the same time sell a "call option" on that same stock:
-Buy xyz company stock at $100/share
-Sell a 6-month call option. In this example the call option allows someone to purchase your xyz company stock for $90/share at anytime prior to expiration (in this example the option expires in 6 months). You receive $18/share for selling the option ($10 real value and $8 premium)

At this point you have paid $100/share and received $18/share, so your net cost was $82/share ($100 minus $18 equals $82).

There were two possible outcomes within the 6-month option period

1) If the price of xyz company stock stays higher than $90/share, the stock will be purchased from you at $90/share. Your net cost of the stock was $82; thus you make $8/share.
($100 minus $18 equals $82 - is your cost)
($90 minus $82 equals $8 - is your gain)

Your 6 month gain was 8.9% ($8 divided by $90). Annualize this and the gain is 17.78%.

Our objective is to keep your money working for you by buying stock and selling options to achieve your annual cash flow objectives. There are periods when we would not buy stocks and this is discussed below.

2) If the stock market fell and xyz company stock was selling for less than $90/share the option would expire and you would own the stock and the $18/share from the sale of the option. Because our net cost for the stock was $82 you had protection against loss down to $82 (this is explained below). And because we still own the stock we can sell another option or sell the stock for you.

Protection Against Loss

In the preceding example we bought xyz company stock for $100 and received $18 from the sale of option. The stock price could fall as low as $82 before you would lose money. In practice there are several additional steps to protect against loss especially in a down market. These are described below.

1) In a down trending market we avoid buying stocks and selling options. Instead we leave your funds in a money market account and wait until the market becomes more favorable.

2) If we were in a position of holding stock with an outstanding option in a down market we could buy back the option and sell the stock. Generally, this strategy can result in little or no loss however there are exceptions to this statement. Another strategy would be to buy back the option and sell another option to protect us from further declines.

ADVANTAGES:
Compared to other types of investments Kensington's Covered Call Program is a strategy that can provide a higher level of cash flow and a degree of protection against loss of principle. Alternatives are as follows:

Stocks and stock funds - Although stocks can provide excellent returns there is no protection from loss of principal should the stock you own drop in price. It is a fact that historically the stock market drops in value as much as 20 percent on an average once every three years. For retirees, loss of principal in the early years of retirement can necessitate going back to work or adjusting lifestyles downward.

Preferred stocks - provide a fixed income, some risk to principal, and often lower rates of return than you may require to meet your goals.

Bonds - also provide lower returns. Junk bonds, in return for higher yields, expose you to risk of loss of principle, especially in a period of rising interest rates.

Annuities - offer guaranteed cash payments but do not allow you to make changes when your income needs change and they afford little in the way of estate planning.

Kensington's staff has had personal and professional hands-on experience with option trading dating back to 1974. We use state of the art software to achieve your objectives.

Because options can be confusing to those not familiar with then we invite you to ask questions. Contact Us