Investors who wish to beat the market using a conservative approach might want to consider learning to invest by using covered call option strategies to enhance their overall return. Writing covered calls helps to improve the total return of an investor’s portfolio if they apply several important principles. There are several strategies that an investor should consider when using covered call options. In Part 1, we introduced covered calls and described the two primary categories that are important to understand. In Part 2 we will introduce the Total Return Approach, as well as the risks, the potential return on investment and what strategy to use given your assessment of the situation. This is part two of a multi-part series on using options to enhance the performance of your portfolio performance. Part 1 of Covered Call Option Strategies introduces covered calls and provides the basic definition.

Complete Return Approach

Investors seek to achieve the maximum return on their investments that is commensurate with the level of risk they are willing to accept. Out-of-the-money and in-the-money covered calls offer different strategies for investors as they seek to achieve their investment goals. In addition to the potential return, you should also consider the downside protection that the option provides. In-the-money writes offer more down side protection, though they can also make money if the stock prices rises. Since the premium on an out-of-the-money write is relatively small, the total position is susceptible to a loss if the stock declines more than expected. On the other hand profit on the stock price rise will not be as much in percentage terms as an out-of-the-money write.

The complete return approach considers the potential return of the stock and the potential return of the covered call write. The decision on what option to write depends on the market trends, the strength of the underlying stock and risk tolerance of the investor. When viewed from the total return perspective, you are able to make better decisions regarding what is the right stock to use and the type of covered call option to write.

Return on Investment

Before writing a covered call, you should understand the potential return so you can make a more informed investment decision. Before entering the covered call position, there are three basic elements of a covered call write that should be calculated. The three are the down side protection, the return if exercised, and the return if unchanged. The best way to describe these factors is to use an example. The table below shows the assumptions for an out-of-the-money call option (TIE AF) and an in-the-money- call option (TIE AE) for Titanium Metals Corporation. TIE AF has a strike price of 30 greater than the current share price of 26.04. TIE AE has a strike price of 25. Both options expire on the third Friday of January 2008. I have assumed $0.10 dividends per share for this example, which is not true for TIE. I just want to be sure everyone realizes that dividends are part of the total return analysis.

For this example we also need to know the net investment required. We are also assuming this is a cash account, so we are not using margin. Margin can increase the returns if performed properly. The table below shows the net cash investment required for each option. Note that the higher premium received for the in-the-money-option provides a lower overall investment.

One of the reasons to write a covered call is to provide some down side protection. After all you are receiving cash by committing to sell your shares at the strike price. Calculating the down side protection is a straight forward process. The table below presents the calculation for the down side protection showing the break-even stock price for each option. Note that the in-the-money-option TIE AE has more down side protection that the out-of-the-money option TIE AF. The break-even price is determined by dividing the Total stock cost by the shares held.

Next you should determine the actual return if the option is exercised. This is where the shares are assigned which would take place if the share price was at or above the strike price and the option is at or very close to the expiration date. The stock price must rise to the strike price in the out-of-the-money option TIE AF.

The table below presents the calculations necessary to compute the return on investment if the shares are exercised for each option. The gain for option TIE AF is due primarily to the appreciation in the stock price. This calculation provides the expected returns you would receive if the options are assigned and the stock is exercised.

The third factor to evaluate is if the stock price is unchanged. That is the underlying stock price is unchanged as the option nears expiration. This allows the investor to more fairly compare the out-of-the-money and the in-the-money covered call writes. In this case note that the out-of-the-money option TIE AF returns 3.8% in the 56 day time frame, while the in-the-money- option TIE AE returns 12.3% over the same time period.

The final factor to consider is the potential return if you buy back the covered call option before it expires. In this case you do not want to wait until the option expires before closing out the position. Maybe you have received most of the time premium in the option and do not want to take the chance it will be assigned as it nears expiration. In this case you will reduce your overall return since you must now spend some of your capital to buy back the option to close it. The amount used in this case is an example. The amount can vary due to a number of circumstances that will cause the amount you must spend to vary.

The Bottom Line

Covered Call options offer investors a way to increase the overall return on their investment as well as provide some down side protection. When learning to write (sell) a covered call you should carefully consider the potential for the stock price rise or fall over the time period of the option. Out-of-the-money and in-the-money options offer investors alternative ways to enhance their position of the underlying security. Be sure to consider both the up side as well as the down side when using covered calls when trying to beat the market.