Wednesday, March 14, 2007

Stock Options

I've been thinking about writing some covered calls, lately. I've been trying to figure out the general strategy I'd like to take, running a few numbers, and asking a few questions of the Internet.

Let's take AMD, for instance. AMD's closing price today was 14.13.
The two main choices I was considering were monthly calls, or yearly. If I wrote a covered call every month, I could make about 1.4% per month in premiums. For instance, April $16.00 calls are $0.23/share. 0.23/14.13 = 1.63%. Then take off a bit for the fact that there are 37 days left instead of 30 and that I'd have to pay a commission. But, 1.4% per month is not a bad return. That ends up at 17% for the year. This is in addition to any stock appreciation!

A January 2008 $17.50 call is 1.29/share. 1.29/14.13 = 9.13%. This looks substantially lower than 17%. There are still other things to consider, though. Let's say AMD releases their Barcelona CPUs and R600 graphics cards early, and Intel doesn't immediately have an answer. AMD could shoot up in price and my option contract may be exercised. In the monthly case, I will make the 0.23/share premium, plus 1.87 in stock appreciation. A nice round $2.10/share. In the yearly case, I'll make the 1.29/share premium, plus 3.37 in stock appreciation. We now have a $4.66/share profit. Still, this is only a fair comparison if AMD surpasses $17.50 in the first month. If it doesn't, the monthly option writing catches up pretty quickly, depending on stock price movement.

It's far less likely that an AMD option will be in the money within a month than it is that it will be in the money within a year. So, writing monthly call options makes me more likely to hold on to my underlying shares. I also have more flexibility to adjust to changing market conditions. Some of the links below also mention that covered calls are more conservative than outright stock ownership.

The premium received does offer some downside protection. With AMD, I see a company that will eventually have a higher stock price. I feel comfortable owning AMD shares long term. I view it as making shares appreciate more. Instead of just getting stock appreciation, I also get option premiums. And I risk the loss of huge profits should AMD skyrocket. I don't see that happening, though. Practically speaking, I'm gaining income, gaining downside protection, and at the worst, only making a significant profit on stock appreciation, rather than a huge profit. I have made it more likely that AMD will be a moneymaker for me. I don't have access to many probabilities, but intuitively, I see my expected return going up at the expense of potentially missing an unlikely surge in stock price.

I'm think I'm going to do it, once I figure out what my AMD target purchase price is.


E-trade options tutorial
Options and Leverage (old and short)
Options and Leverage (new and long)
Covered Calls

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