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Two Simple Tools to Help Grow your Business in a Volatile Market - Continued


Probably one of the most popular strategies over the last several years has been the covered call. Assume an investor is long 100 shares of Walmart (WMT) at 54. If she is like most of the investing public she will hold the shares for the “long run” and wait for the stock to appreciate. However the investor who understands options may decide to write (sell) a call against the 100 shares of WMT and collect the option premium. This option premium can be used as source of income for the stockholder, not unlike a building owner collecting rent from his properties. The tradeoff is that she gives up her claim to some of the upside in the stock from the date the option is written to its expiration date. For example, assume the advisor recommends writing the December 57.50 call for $1.50 per share. If the stock stays below $57.50 between now and the December expiration, the investor keeps her 100 shares (along with the $1.50 or $150 collected for the calls). A stock price at expiration of over $57.50 means that the calls will be exercised and the investor will have to deliver the stock at $57.50, missing out on any appreciation of the stock above this level.

WMT Price  
+100 shares
WMT P/L
+100 WMT &
-1 Dec 57.50 call @ $1.50
P/L
60
600
500
57.50
350
500
55
100
250
54
0
150
52.50
-150
0
50
-400
-250



 

Using a covered call works best in a range bound market. A conservative investor who is unsure about market direction may find this strategy handy for bringing in additional returns. But if someone is extremely bullish on a stock it may not make much sense. Additionally, a covered call offers limited protection against a drop in the price of a stock – note that in our example above the covered write breaks even at a price, at expiration, of $52.50. The stock can only fall by the amount of the call premium received before the investor shows a loss on the strategy.

 

 

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