traders' guide to increasing retirement income with options

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Traders’ Guide to Increasing Retirement Income with Options

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Copyright © 2011 by Ernie Zerenner

Published by Marketplace Books Inc.

All rights reserved.

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eISBN: 978-1-59280-459-7

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How to Increase Your Retirement Income

One of the major reasons we work is to prepare for retirement. This should be especially true now, since so many “baby boomers” are reaching retirement age. We are all living longer, our healthcare is more expensive, and our social security is dwindling—inevitably, we will need

more money to handle our living expenses and pass times.

After working for 30 plus years, things may start to change. Perhaps the fire in your belly is gone. You are losing respect for your boss or maybe the original founders of the company are no longer active and the per-sonality of the company has changed. Something is missing and work isn’t as much fun. There may be a buy-out in the wings because of a restructure or any one of a dozen other things happening to make you seriously consider the prospect of retiring. We all have our reasons for transitioning to retirement, and it will happen to all of us at some point along this journey called life.

ReTIRInG Is One Of lIfe’s majOR evenTsIt has a major impact on every facet of your life psychologically, financially, and socially. Although much can be written about the psychological and familial changes in retirement, this chapter will concentrate on the financial considerations of the retirement transition. Financially, you are moving from salary and wage income for services rendered to relying on other forms of income for support. There are no more raises or bonuses and you have to live from the assets accumulated over your past working life, various pension plans provided by your employer, and the government social security (SS) program, if you are eligible. In my case, I retired at 57 years of age and SS was not available for several years yet. Therefore, I had to depend on generating an income from my assets.

I was probably better prepared than most for making the transition to retirement. During my 35 plus years of employment, I was an active investor. For more than 40 years I traded stocks, commodities, and options.

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Most of this investing was fairly aggressive, with my objective focused on capital appreciation. My career was in project engineer-ing and engineering management, so my professional life prepared me with the skills and tools to plan for major changes. Once the deci-sion was made to retire, the plan-ning mode moved into high gear. The first step was to evaluate my current situation.

YOuR CuRRenT fInanCIal POsITIOnLike many of you, I had some cash and stocks, but most of my assets were in a 401K and company-sponsored retirement fund with my employer. One of the things I realized during this assessment period was how much of my assets were tied up or dependent on my employer. Not only was my employment and salary tied to my employer, but much of my 401K and pension funds were tied to my employer’s stock. I was familiar with the need to diversify one’s holdings, but over time the com-

pany stock kept accumulating through subsidized stock pur-chases and performance stock options. Company performance stock options can be particu-larly treacherous. A colleague of mine lost almost a million dollars of his retirement funds because he held the options during the 2000 market crash. The options became worthless as the stock price of our company dropped below the exercise price of the option. For several years before actually retiring, I systematically sold company stock and reinvested the proceeds into other companies outside our industry and moved some cash into mutual funds for diversification. This diversification move paid off because my com-pany stock dropped from $60 to under $20 during the crash, while my mutual funds were only off by 30%. Holdings using the strat-egy outlined below were only off by 20%. So listen up, it could be worth a lot of money to you in retirement if done correctly and conservatively.

Most of the shares sold to raise cash for diversification were short-term holdings. And most of the shares I retained were long-term holdings. Since the long-term shares were accumulated over a long period of time (30 years), the cost basis was very low. In most cases, it was only a few dol-lars compared to the present $60 price of the stock at the time of sale. This can happen very easily since company-awarded options can have a 10-year lifetime. As an example, your company stock may sell for $40 per share and over a 10-year period split twice; two for one. Your equivalent pur-chase price will be $10 per share

when the present price is $60. That would be a capital gain of $50 per share. If the option were giving you the right to buy 10,000 shares, then the tax would be on $500,000. If those shares were sold, the tax burden would have been very great even though he or she would have received favorable capital gains treatment. Keep this in mind as we proceed because the strategy in handling these long-term shares will be different from the cash generated from the sale of the shorter-term holdings.

As you can see the planning pro-cess was under way even before I actually retired. Many of my col-leagues who retired around the

Holdings using the strategy outlined below were only off by 20%. So listen up, it could be worth a lot of money to you in retirement if done correctly and conservatively.


same time used financial advisors to facilitate this process. Because of my financial experience, I was able to make most of these deci-sions on my own. I consulted sev-eral advisors during my 40 years of investing, but ultimately made most of the changes myself. I was a self-directed investor. The remaining discussions are the self-directed steps I took to secure my financial future in retirement. One alternative my employer provided in retirement was to convert all of my corporate stock and holdings into cash to buy an annuity. The annuity would have provided a fixed income for the rest of my life in exchange for the cash. In this case the equivalent return on the money would have be about 6-8% per year, but I was confident that I could earn over 12% per year for a 50% better return than the annuity offered. This is another case where the decision to go self-directed influ-enced the approach I took to invest my retirement funds.

The first several steps of the plan-ning process:

• Make an assessment of the assets available for retirement.

• Decide if an advisor or I would manage the retirement portfolio. Since I had bad experiences with previous advisors, brokers, and mutual funds, I decided to go self-directed.

• Diversify out of any high concen-tration of company stock.

• Determine the tax implications of the long-term stock holdings.

• Move from capital appreciation to income generation.

• Become less speculative and more conservative in my invest-ment approach.

• Move to mitigate large negative changes in the assets because there would be less time for sal-ary income to repair or recover the damage.

• Determine what forms of protec-tion would be required to keep

the portfolio from large negative changes.

This planning process led me to an investment strategy that enabled me to create income from my stock and cash assets and to reduce the volatility in my hold-ings. And, it was more conserva-tive than just holding stock or mutual funds alone. About half of my funds were put in large diver-sified mutual funds and the other half were invested in an invest-ment strategy generally known as Covered Calls. Covered Calls are a neutral to bullish strategy, which expect your stock to stay the same in price or go up in time. It is a strategy for generating income and providing some downside pro-tection, as opposed to a capital gain strategy.

WanTed: TOOls fOR COveRed Call InvesTInGOnce I decided to use covered calls as an income generating strategy, I looked for tools that were available to help find oppor-

tunities. However, in 1997 when I was ready to retire, there were very few tools to help learn about the covered call strategy, calculate covered call returns, find covered call stocks, or analyze a covered call position. Even my broker at the time could not help provide more detailed information about the technique. Up to this point I had dabbled in covered calls and was somewhat familiar with the technique, but now that I was going to retire on the income from covered calls, I needed a great deal more information before I could feel secure. It was taking me a few hours each weekend to find the best stocks, find the best options, and do the return and income cal-culations. There had to be a bet-ter way to invest my retirement funds than spending all this time. After all, wasn’t retirement sup-posed to be a time to pursue other interest and not worry about earn-ing money? A colleague of mine was retiring at the same time as I was. We discussed the problem of not having any tools to help


with covered call investing. Since we were both skilled in develop-ing software from our previous employment, we decided to create a computer program to solve the tool problem. We used the power of the Internet to gather the data and used computers to do the calculations. The Internet site we created was called PowerOptions (www.poweropt.com). Since 1997, we have built a winning team to support and continue develop-ment of the tools and strategies PowerOptions offers. We now include over 150 pages in our award winning web site and cover 20 of the most popular option strategies. PowerOptions has been reviewed and acclaimed by many in the industry: Forbes, AAII, Active Trader Magazine, New York Post, and Nightly Business Report to name a few. PowerOptions is so innovative, the US Patent and Trade Office issued us patents in 1997 and 2007, covering some of its unique features.

COveRed Calls: a GReaT WaY TO COnTROl RIsk and CReaTe Cash InCOmeThe covered call strategy requires the use of call options. These are options that are bought and sold on the open market as opposed to the company-issued options men-tioned previously. Also the options are used in a different way (com-pany options give you the right to buy company stock from the company). More specifically, the strategy requires that we sell call options.

In order to talk more in-depth about this strategy, let’s discuss some basic background informa-tion on options. The public gener-ally thinks of options as specula-tive financial instruments. This is not necessarily true. There are dozens of investing strategies that use options spanning from very aggressive to the very conserva-tive. Most of the abuses in the use of options are at the speculative end. The covered call strategy is a conservative strategy used by

investors as opposed to specula-tors. It uses one type of option, a call option. Options are financial instruments that give the buyer (of the call option) the right, but not obligation, to buy a particular stock at a set price called the strike price. For every buyer of a call option, there is a seller. If you sell an option, you are called a writer because you are actually creating the option on the stock. The seller of the call option is obligated to sell stock to the buyer if the buyer exercises their right to buy.

In general the buyer of a call option is a speculator hoping to gain leverage on a price gain in the stock. Leverage is obtained because the cost of the option may only be 10% of the cost of the stock. Therefore, the specula-tor controls the stock with only a 10% cost. If the stock goes up, he or she can make large sums, but if the stock goes down he or she could lose the entire cost of the option. A covered call involves writing the option and making your shares available through the

option to be sold to the specula-tor. Since you own the shares, they act as security for the obli-gation of the sold call. The call option selling process, in this case, is a conservative way to generate income. The percentage return you receive is not highly depen-dent on the price increase of the stock. The price (premium) you get for selling an option against the stock you own is based on 5 factors:

1. Stock price—price of the under-lying security

2. Strike price—the fixed price the buyer will pay for the stock

3. Volatility—how much the stock generally moves over the previ-ous year. The more volatile a stock, the higher you can expect the premium to be on the option.

4. Time—the amount of time allowed to exercise the option. The more time allowed to exer-cise the option, the higher the premium on the option.

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5. Interest rate—the risk free inter-est rate available.

In general, selling covered calls can generate several percent each month. This strategy is conserva-tive enough to be allowed in an IRA account. Most of my retire-ment funds were in a 401K and a company-sponsored retirement fund. These funds were all placed in an IRA Roll-Over account. Once rolled-over into the IRA account, these funds were used to imple-ment the covered call strategy. Covered Calls generate income, which would be classified as ordi-nary income from a tax point of view. A covered call process in an IRA account is an ideal situation because the income generated is sheltered from immediate taxa-tion until it is needed at some time in the future. In the meantime, funds can accumulate and com-pound tax-free.

The covered call strategy is very simple on paper. One just buys a stock and then writes (sells) a call option against the stock owned. This method of investing is much like owning real estate that you rent out to tenants. The stock you own is analogous to the ownership of real estate, and the call option creates the rent for use of the asset. Writing a call option cre-ates an income (rent). In exchange for paying you the income, the call buyer has the right to buy your stock for a stated price (strike price) for some period of time (the lease period in a rental). The stat-ed price for the option is called the strike price and the ending time to buy the stock is called the expira-tion date.

These definitions can be difficult to get your arms around with-out an example. Let us assume you own 1,000 shares of Hewlett

If you want to learn more about the covered call strategy there are many books, courses, and seminars on the subject. These educational sources range in price from $3,000 to $20 in price. A home study educational kit developed by the author is available for $199 at http://www.poweropt.com/ccoffer.asp.

Packard (HPQ) stock, whose present price is $40 per share. If you now sell someone the right to buy your shares at $40 per share (strike price) any time over the next 55 days (expiration time), then he or she will have to pay you $1,700 (option premium) for that right. That is equiva-lent to a 4.4% return in 55 days or over 29% annualized. This return is without any expectation of the stock going up or down. It is the static or unchanged return. Remember our goal was to beat the annuity rates and earn more than 12% per year. As you can see this can be very easy to achieve (refer to figure 1).

Stock: Hewlett Packard ($40)Stock Symbol: HPQStrike Price of Option: 40Month of Expiration: May Option Symbol: HPQEHOption Bid Price: 1.70 (with 55 days to expiration)The return is calculated as: Return = Income / Amount invested = 1.70 / (40 –1.70) = 4.4%Annual return = (Return * 365) / (# days to expiration) = (4.4 * 365) / (55) = 29%

Profit/Loss

StockPrice

+

+–

–

Figure 1

http://www.poweropt.com/ccoffer.asp


In the return calculations in figure 1, I show the amount invested as the price of the stock minus the option premium received. Most sources show the calculation in this way, although there are oth-ers who prefer not to subtract the premium for the stock price. I sup-port the first approach because the premium is immediately deposited into your account; therefore, the next day when you look at the cash available to invest, you will see that there has been only $38,300 (40,000 – 1,700) removed from your account to pay for the cov-ered call position. This amount is called the net debit. Many brokers will allow you to specify the net debit of the transaction and exe-cute both the buying of the stock and the sale of the call as if it were one transaction. In this way the investor does not have to be con-cerned about buying the stock first and having the option price change before the expected sale of the call can be executed.

During the 55 days that we “rented out” our stock for a fee of $1,700,

there were three things that could have happened:

1. The stock goes up, and we allow our stock to be bought at $40 per share and keep the $1,700 paid for the right. We end the 55 days with $40,000 paid for our stock plus the $1,700 of income for a total of $41,700. We made 4.4% on our asset and can repeat the buy-write process.

2. The stock remains at the same price, and we lose our stock for $40 per share and keep the income as in the previous case. Again, we make 4.4% on our asset in 55 days and can repeat the process.

3. The stock goes down. In this case, we just keep the $1,700 and rent out our stock for another 55 days. We still own the stock and can continue to rent it. If we just owned the stock, any decrease in price is a loss. But by writing the covered call, we have some downside protection. In this case up to $1,700 of downside protection.

To continue the real estate anal-ogy, notice several facts:

• There was no collection problem with the rent. It was paid up front and delivered into our bro-ker account the very next day.

• Just like in real estate, it did not matter if the asset value (stock price) went up or down; we kept the rent.

• There are no maintenance fees or real estate taxes.

• No plumbing problems or calls in the middle of the night.

• There are commissions on the sale of the stock and option, which may have cost $23 (1.3%) and not 3 to 6% like a real estate sale.

• We do not have to worry about fire, theft, or liability insurance.

• You can’t be harassed by tenants or sued.

• There is no need to advertise for new tenants; the market provides an endless number of takers.

This is all a very clean and easy source of income. In two of the three cases above, you made a very nice return. And in the third case, when the stock went down, you reduced your losses by $1,700, which is better than if you just held the stock. Therefore, you are better off in every case. A pos-sible negative would be the loss of potential gain if the stock went to $50 / share. In this case you would only make the 4.4% return and get forced to sell out at $40. However, in retirement we gener-

This is all a very clean and easy source of income. In two of the three cases, you made a very nice return.


ally do not want to speculate on the rise and fall of a stock. We want stability and low volatility. The cost of the downside protection and the steady income is the potential loss of participation in the price increase of the stock.

But the covered call strategy even has an answer for the case of high stock appreciation potential. We are always in control of the risk / reward with this strategy. If we would have offered out our stock at a strike price of $42.50 instead of $40, we could have made an additional $2,500 if the stock went over $42.50. Of course we would not have received $1,700 from our potential buyer; they would have paid only $650 for the right to buy our stock at $42.50. Using this higher strike, there is a continuous risk / reward trade-off depending on the strike price of the option. In most cases, the covered call writer would take the guaranteed $1,700 rather than the $650, which would be specula-tion on the price appreciation. Therefore, covered call writers will gen-erally write the call close to the price of the stock, where as a speculator might sell the $42.50 out of the money (OTM) strike in anticipation of the stock’s price appreciation.

In the OTM example, we considered the aggressive case in anticipation of a stock rise. However, what if we are concerned about a fall in the price of the stock? In most cases, you could just sell your stock if you

expected it to fall, but an alternative is to sell a lower strike price that is in the money (ITM). By using a lower strike price of $37.5 instead of the nominal $40 (ATM, at the money), we can build in some downside pro-tection. The stock could fall to $37.5, and we would not lose any money from the decline in the stock. Typically, the option price will be about 2 points higher (i.e. $3.70 as opposed to $1.70) for this lower strike price, which makes up for the fact that it could be exercised at a price lower than the present market value. In reality, this seldom happens because there is still more than a $1 premium in the option, and the stock could be bought on the open market for less than using the option to acquire it. It is actually desirable, from the writer’s point of view, to have an ITM option exercised early because you realize your profit in less time and therefore increase your returns. By writing the ITM strike at $3.70, the investor can lose 3.70 on the price of the stock and still break even. Therefore, by writing ITM you get more downside protection compared to investors who write ATM or OTM. However, the increased downside protection sacrifices the potential return from the covered call. If the stock remains unchanged or at the strike price of $37.50, then the return is only 3.3%.

Return = Net Income/Amount Invested = (3.70 – 2.50) / (40 – 3.70) = 3.3%

A good way to see the risk / reward tradeoff is to list the returns or each case ITM, ATM, and OTM from an option chain that calculates the returns for each strike price. The three cases that we discussed for Hewlett Packard @ $40.55 are summarized in table 1:

...in retirement we generally do not want to speculate on the rise and fall of a stock. We want stability and low volatility.


Table 1. Risk – Reward Tradeoff vs. Strike Price

1 Strike Price

of the option

2Option

Premium 54 days out

3% Downside Protection

4% If Stock

price is unchanged

5% If cov-

ered call is assigned

6% Probability

of being above strike

37.50 (ITM) 3.60 8.9 1.5 1.5 8840.00 (ATM) 1.80 4.4 3.2 3.2 5842.50 (OTM) .65 1.6 1.6 6.5 24

Table 1 can be used to visualize how the choice of strike price can be used to create a risk / reward tradeoff. The strike prices used in the pre-vious examples are listed on the left. In the second column, the option bid price for each of the strike prices is listed. The highest absolute price is for the ITM strike. Because this strike is ITM, some of the premi-um consists of what is called intrinsic value. Intrinsic value is the inher-ent value of the option based on the selling price of the stock relative to the strike price. Therefore, the intrinsic value of the option price is:

Intrinsic Value = Stock Price – Strike Price = $40.55 – $37.50 = $3.05

This means that the stock is actually selling $3.05 higher than the strike price, which is the value we are required to sell our stock for at expira-tion of the option. The part of the option premium that represents the price paid by the buyer for the time he or she has to exercise the option is called Time Value. The option premium price is made up of the sum of time and intrinsic values:

Option Premium = Time Value + Intrinsic Value

And

Time Value = Option Premium – Intrinsic Value = 3.60 – 3.05 = $0.55

The reason that this is important to you as an investor is because the intrinsic value is just a return of value based on the price of the stock, and the time value is the actual part of the premium you receive for making your stock available. Intrinsic value helps provide downside pro-tection but does not contribute to your overall return. Column three shows that the highest downside protection is achieved by the ITM strike price. At the same time, as seen from column four, the highest returns come from the strike that is ATM and not the strike with the highest premium. The fifth column shows the returns possible if the stock is assigned. When the stock goes over the strike price, it will be assigned or sold to the option buyer. Note that the highest return, if assigned, occurs for the OTM case. This is a very attractive return for 54 days, but it requires that the stock rise in price from its present $40.55 to $42.50 during this time. In the last column we show the probabil-ity of each of these events happening. The probability of earning 1.5% with the ITM strike is a very high 88%, and the probability of earning the 6.5% is only 24%. This table can be summarized by:

• The most conservative investors go ITM to obtain the highest down-side protection and have an 88% chance of success.

• The highest covered call returns are obtained ATM and generally have about a 50% chance of success.

• The overall highest returns are obtained OTM by speculating on the rise in stock price with only a 24% chance of success.

We could have received more income if we would have given the specu-lator more than 55 days to buy our stock, but most covered call writ-ers go out only about 25 to 60 days in time to maximize their returns. Longer time frames bring in more money, but the income is not com-mensurate with the increased time. In general, the annualized returns will be less as you increase your income by going further out in time.


Therefore, you receive higher returns and you collect more total money over one year if you write for shorter periods of time and repeat the process several times in one year. The ATM covered call example could be done at least 6 times a year bringing in 6 times $1,700 or $10,200 in 12 months. For the particular stock in our example (HPQ), the best period for writing was every 2 months. But most frequently it will be most advantageous to write every month. The best way to observe the optimum frequency of the write cycle is to examine the option chain that contains annu-alized returns. A typical option chain for Apache Corp (APA) is shown in figure 2.

Note the column for annualized returns and then scan down look-ing at the same strike price for each month.

Figure 2

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Table 2 lists a summary of the returns for several different months shown in the chain.

Table 2. Summary of Returns per Expiration Month

1 Month of expiration

2Strike Price

3Option

Premium Bid

4% If Assigned

5% If Assigned Annual

April (25) 70.00 1.55 2.2 32.2May (53) 70.00 2.55 3.7 25.6July (116) 70.00 3.90 5.8 18.4

From Table 2 we can see that the option premium, in column 3, increas-es as the time goes out to later months. The % if assigned, in column 4, also increases as the time to expiration gets longer. However, also note that the % if assigned did not double even though the time doubled from April (25 days to expiration) to May (53 days to expiration). The return only moved from 2.2% to 3.7%, and not to an expected 4.4%.

The best way to illustrate this loss in return with time is to use annu-alized returns. In the last column (5) we can see that the annualized return continues to decrease when the time is increased for the covered call write. For this stock, clearly, writing every month would have pro-duced the best annual returns. Even though the premium for each write will be less by writing every month, the cumulative sum of all the writes will be larger than doing one large write.

The COveRed Call ReTIRemenT PROGRamThere are fundamentally two cases for entering a covered call retire-ment program. One: you already own some stock and would like to write covered calls against that stock. Two: you are primarily in cash and want to buy some stock and write a call against this new purchase.

This second process is called a Buy-Write, i.e. buy the stock and write the call.

In the first case you probably want to retain possession of the stock and not have it assigned as part of your covered call process. My long-term stock holding applied to this case. Since the stock was acquired over many years and had a very low cost basis, the tax burden on the sale of the stock would have been very large. Therefore, it was important to avoid having the stock assigned and sold to an option buyer. Once the option was written, it had to be tracked and action taken if it were to go in the money (ITM).

The situation is that once the price of the stock rises over the option strike price, it is vulnerable to being exercised. If the stock gets assigned, it cannot be reversed. It will be sold and you will be stuck with the tax consequences of the sale. To avoid being assigned, you need to buy the option back and re-write it at a higher strike price, which is out of the money (OTM). Actually, the risk of being assigned when the stock goes ITM is very small. If the stock is a high dividend paying stock, it will have a higher probability of being called early, espe-cially if the ex-dividend date is just prior to the expiration date of the option. In this situation, the investor who holds the buy option wants to exercise to own the stock in time to get the dividend. As the stock goes further ITM and the time to expiration gets closer, the probability of assignment increases. My general rule of thumb is to take action on the ITM option if it is less than one week to expiration or if the stock has moved up to the next possible strike price for an option.

To summarize the process for stock you already own:

• Use an option chain that calculates the return if unchanged and if assigned.


• Choose an expiration date between 25 and 60 days out in time to maximize your annual-ized return.

• Choose a strike price near the current stock price or next OTM to avoid loss of the stock.

• Collect the income and repeat the process after each expiration date.

• If the stock goes ITM and you want to keep the stock, consider buying back the option and roll-ing up to the next strike price.

In the second case, you must find an optionable stock to purchase. There are about 3,000 option-able stocks and over 200,000 options on these stocks. Finding the correct stock is very important because the fate of the option you write is dependent on the under-lying stock. It makes no sense to choose the correct strike price on the wrong stock. You can specify what a good stock is by choos-ing fundamentals, technicals, and option parameters, and then use

a tool like PowerOptions (http://www.poweropt.com) to screen through possible options for cov-ered calls. It will allow you to search through every possible stock and option, finding the ones that are best suited to your requirements. Even if you are not sure of how to set all the screening parameters, the default settings can be used to get you very close to acceptable solution of finding a potential list of covered call stocks.

focus on stocks Going upWriting covered calls is a neutral to bullish strategy. You are expect-ing the stock to go up or stay at the current price so you can ben-efit from the call premium written. Therefore, you want to use screen-ing parameters, which will increase the probability of your stock going up in price. Stocks go up in price when their earnings and sales are strong, when brokers and institu-tions are recommending them, and when the charts show they are in an uptrend. It is also some-

time useful to follow recommen-dations from independent evalu-ation services like—Value Line or Standard & Poor’s.

These are all characteristics that can be used in the PowerOptions Web application mentioned earlier. The tools on PowerOptions were specifically designed to find and analyze covered calls, although many other strategies are support-ed. If you presently have a stock selection method that you feel has been successful, that may be a way for selecting your covered call candidates. In either case, you should feel confident in the pros-pects of the stock selected.

diversifyIt is also important to have a diver-sified portfolio. Diversification comes in two forms:

1. Allocation by financial asset class.

2. Diversification within an asset class, such as stocks.

You do not want to have too many eggs in the same basket for either an asset class or within an asset class. In the first case, examples of an asset class would be bonds, real estate, U.S. stocks, foreign stocks, or cash. The second type of diver-sification is within that asset class. As an example, your bond portfo-lio should have several different bonds in it not just one. For our discussion on covered calls, we

You do not want to have too many eggs in the same basket for either an asset class or within an asset class.




are referring to this second level of diversification in the stocks we own. This is similar to our concern about having too much of your company stock. Try to spread your stock holdings out over several industries and have at least 10 dif-ferent companies represented in 5 or more different industries. In the case where you do not have enough money to hold 10 different companies, consider doing a buy-write on an ETF, Index, or Trust that is diversified.

Many ETF’s are industry-specific and would not provide the diver-sity needed, therefore, look for a broadly based diversified index. As an example, the NASDAQ-100 Trust (QQQQ), which represents the 100 largest companies on the NASDAQ, would provide the diver-sification and participation in the general growth of the market. This trust has call options that can be written to form covered calls. When an index or trust like this is used for covered calls, the returns are slightly lower, but then the risk is lower because of the lower

volatility of the index. The risk is also lower because you do not have to be concerned about some negative event that is company-specific, like a bad earnings report, a scandal, or FDA rejection. The impact of such an event on this index will be only 1/100th of what would happen to the stock alone. You may want to consider starting out with an index and then slowly, over time, adding individual stocks as your portfolio grows in value. In my own portfolio, I do buy-writes on individual equities to get the higher returns.

• To summarize the covered call buy-write process:

• Find a stock or index that meets your requirements and is expect-ed to go up in price.

• The stock should already be in an uptrend (in a bear market you may not find any, just wait).

• Buy at least 100 shares of the stock (you need 100 shares per option contract).

• Sell one call contract for every 100 shares you own.

• Choose an expiration date between 25 and 60 days out in time.

• Choose a strike price near the current price of the stock or slightly ITM.

• Write the call and collect your income.

• Repeat the process after each expiration date.

Writing covered calls takes some practice and experience just like investing in real estate or stocks alone. The covered call strategy will enable you to increase your income in retirement and provide

some downside protection from market declines.

manaGInG YOuR COveRed Call POsITIOnsNow that you have done your first buy-write, “How do you maintain the position?” Generally, it will pay to watch the price movement of the stock and the option over the course of the month to see if any further actions should be taken. Many covered call inves-tors just hold until expiration and repeat the buy-write process. However, when there are large movements in the stock over the intervening month, there may be an opportunity to improve your

The covered call strategy will enable you to increase your income in retirement and provide some downside protection from market declines.


returns by taking some actions during the month.

The following suggestions are based on the philosophy of being hedged at all times. By hedged we mean you always have a call written against your stock to provide downside protection. In the “General Tactics” section, we assume you want to hold the stock for the long term. Portfolio

fluctuation should be more inde-pendent of the movement of the market because one would always have a covered call position. Being hedged at all times should mini-mize the volatility of the portfolio, and therefore, limit both upward and downward movements in the value of the portfolio.

The management principles sug-gested should allow one to par-ticipate in 70% of the rise in stock price and limit losses to only 30% of the decline. These percent-ages work as long as the trading is orderly. If the company rises quick-ly because of a take-over or falls because of an accounting irregu-larity, the stock move could gap up or down. This would make it more difficult to follow the plan. In the

management tactics discussed, the assumption is that a covered call was initially written at the money (ATM). Some investors specialize in an in the money (ITM) or out of the money (OTM) strategy. These strategies are discussed at the end of this management section.

exitingFollowing your writes and know-ing when to exit can be a difficult and exhausting game. The trick is to know when you should take action on your positions. It is pos-sible to go out too early if you get nervous right away after a slight drop or rise in the stock price. Of course, you can also be too patient and wait too long to take any action and let a position get away from you.

When dealing with covered calls, there are three main scenarios a writer must be attentive to as expiration approaches:

1. What can be done if the under-lying stock suddenly rises?

2. What can be done if the under-lying stock suddenly falls?

3. What can be done if the stock price stays the same?

In each situation there are tips and guidelines that can be followed in order to exit the position. Of course, each possibility mentioned above can also be affected by your

investing strategies. Do you write In the Money (ITM), At the Money (ATM) or Out of the Money (OTM)? Each strategy has slightly different guidelines for swings in the market. The first strategy considered is the ATM case for a long-term holding.

General Tactics/Rules of Thumb

Let’s first discuss the general rules of thumb for exiting a covered call position. Exiting action should gen-erally be taken any time the stock price moves to the next strike price from the original strike price. If a stock is purchased at $20 and the next month’s $20 strike call is written, action would be taken when the stock moves to $17.5 (down) or to $22.5 (up). There is generally no rush to move imme-diately. In fact, if you give it a few days, it will help the option prices stabilize and allow you to wring a little more time premium out of the position.

Let’s examine the case of the stock falling (Buy stock at $20 and write the 20 strike).

By hedged we mean you always have a call written against your stock to provide downside protection.


If the stock falls to $17.5, we would consider buying back the call writ-ten at the 20 strike. The option should have fallen in price to a considerably lower value than when originally written. Our objec-tive would be to purchase it back at the lower price and write it again at a lower strike price so we can remain ATM. We would con-sider writing the lower strike price out one month further in time, not necessarily in the same month as the original write. This would be especially so if the time remaining to expiration was only one or two weeks out. Therefore, we would track the stock down in price to maintain the hedge and get more option time premium for the fall-ing stock.

It should be noted that tracking the stock down like this assumes you want to maintain your posi-tion in the stock and that you have not changed your mind about holding on to it for the long term. Each time that the stock drops to the next lower strike price, you buy back the old option and write

a new position ATM or slightly in the money (ITM). It is important not to let the dropping stock price get away from you. If it falls too far without you taking action, you will lose the safety of the hedge because there will be very little premium to cushion any fall in the stock price. Remember, although you can continue to hedge your portfolio by following the stock down using this method, if the stock keeps falling, you might want to reevaluate your position and decide if you even want to keep the stock.

Let’s take a look at the case of the stock rising (again, buy stock at $20 and write the 20 strike).

If the stock instead rises to $22.5, again we should consider buy-ing the option back and writing the call at the $22.5 strike price. Buying back the short call may cost more than the original value of the write since the option is now ITM. How much the option will cost depends on how soon after the write the upward move

takes place. The closer the option is to expiration when the upward movement of the stock takes place, the less the premium there will be since the time value has decreased. If the rise happens just after the stock purchase, the

option premium will generally be higher. However, your holdings in the underlying stock will go up faster than the price of the option. Therefore there should always be a net gain. After the option is bought back, immediately write a new covered call at the next high-er strike price.

You may also want to consider going further out in time to get more time premium and to mini-mize the loss of the buy back. Generally, the net cost of the buy back and new write should allow

you to capture about 70% to 80% of the stock’s rise in price. Again, it is important to track the stock’s rise with timely buy backs if you want to participate in the rise of the stock. Since you are ahead when the stock rises, it even may

be prudent to let the subsequent write be a little more in the money (ITM) as the stock rises. This will hedge the rise a little more, but also will limit the complete par-ticipation in the rise of the stock price. Each time the stock rises to a new strike price, we should consider buying back the original covered call and writing a new covered call at the higher strike price and moving further out in time to retrieve most of our buy back costs.

It is important not to let the dropping stock price get away from you.


The Importance of Time value

Another consideration in timing the buy backs is to look at the time value remaining. This value is essentially the earnings for a covered call. When the time value gets too small, there is little premi-um to be made from the covered call, and it is time to take action. The purpose of taking action is to capture some more time pre-mium. Time value is maximized when the stock price is equal to the strike price (ATM). As the stock rises or falls, the time value will also fall. This creates the oppor-tunity to buy back and roll up or down to collect a higher premium. Generally, when the time value falls to less than 2%, you might want to start looking for buy back opportunities. When time value drops to 1%, you should definitely consider taking action. The excep-tion to this rule of thumb is when there is only about a week left to expiration. In this case we may just wait it out to avoid the buy back commission. Managing your portfolio in this way should reduce

the volatility in the portfolio and stabilize your returns.

deep In The money (ITm)

Some investors use a deep ITM strategy to be more conservative and provide more down side pro-tection. When a buy-write is done ITM, there is a smaller return, but the down side protection can often be 10% or more. These investors expect that their stock will be called, and they will benefit from the return provided by the premium. If you are a conserva-tive investor and do not want to tolerate the risk of a stock fall, the down side protection can be used as a stop point. Once the stock declines to the ITM strike price, the option price will change much slower with a stock price decline. Therefore, most of the protec-tion comes from the ITM (intrin-sic value) part of the premium. If the stock has declined the entire ITM amount of 10%, it just may be time to liquidate and move on to another issue before the losses get too large. In this case, you can

hold the position to expiration and let the option expire worthless, or you could buy it back and write a new call at a lower strike price either one month or more out in time.

Rolling Out Your ITm Covered Calls

Let’s again take our example of XYZ at $20, and this time, we are going to write a 17.5 strike. How can we roll these options out when the stock moves?

Scenario 1: The stock price drops from $20 to $17.5. Our covered call is now closer to ATM then ITM. If you wish to stay in the money and you think the stock price will not come back up, you can buy to close the 17.5 covered call and write out a 15 strike for the same month. In this case, you might be able to collect more pre-mium if you write the 15 strike one month out in time. The cost to buy back the original 17.5 may now be significantly lower than the premium you originally collected for it. The new write of the 15

strike will also give you a new ITM premium. Although this sounds good, keep in mind that you are still losing money on the underly-ing stock. If you are planning on getting assigned and you think the stock price will rebound from the initial drop, you can leave the 17.5 strike alone. In this case you want to watch the time value on the option carefully. Once the time value decreases to 2% or less, you might want to consider acting on the option.

Scenario 2: The stock price hov-ers around $20 a share. Your ITM option remains ITM. You will most likely get assigned at expiration. This is the ideal situation. Just sit back and let the stock get called away. You made your entire expected profit from the position.

Scenario 3: The stock price rises to the next strike price of 22.5. You are now deeper ITM. As the stock rises, you can buy back the 17.5 and write a 20 or a 22.5 strike price for the next month out. The buy back ask versus the new bid


price will most likely be a nega-tive value. It will cost more to buy back the option compared to the amount you made on the original write. However, keep in mind that when you are rolling up with the market, you may be losing money on the buy back costs of the option but you are gaining money on the underlying stock. You can also simply close the position on the option and use the profit from the increasing stock to off set any losses you might have incurred.

Out of the money (OTm)

Some investors use an OTM strat-egy. These investors generally have held the stock for a long time, which was the case with my company stock that I accumu-lated over 30 years and did not want called away (assigned). It is anticipated that the vast major-ity of these trades will result in the option expiring worthless. Investors might also prefer not to heavily manage the covered call. Therefore, the strike price is gener-ally chosen far enough out of the

money (OTM) that it will not be called. The OTM strategy is also used by investors who think the stock may have a strong upward move. Writing more OTM will therefore allow you to participate in larger stock gains. If the stock price rises above this deep OTM strike price, generally the option will be bought back to avoid being called. You can then write another call at a higher strike price to con-tinue to participate in the upward movement of the stock and avoid having the stock called away.

If the stock declines, the option premium will go down, but since it started OTM it will move down more slowly. Once the premium gets to a very low value, i.e. $.05 or $.10, you may want to con-sider buying it back and rolling to a lower strike price to get some more premium. The exception to the buy back would be in the last week or two when it would pay to just wait it out to avoid the trans-action commission.

Rolling Out Your OTm Covered Calls

Let’s again look at our example of XYZ stock selling at $20 but let’s assume that we wrote a 22.5 cov-ered call strike price. What can be done to roll with the market in this situation?

Scenario 1: The stock price drops from $20 to $17.5. Your covered call is now further OTM and will expire worthless. You will keep the premium that you have already collected for the position. To keep collecting premiums on the stock, you can write the 22.5 out again for the next month out after expi-ration, or you could also write the 20 strike if you felt the stock was going to remain down. If you notice that the stock continues to drop below $17.5, you might want to reevaluate your position on the underlying stock. If you continue to roll down with the market, you will be able to hedge the loss on the stock, but remember, there will be a point when you lock in a loss that cannot be countered with the premiums from the options.

Scenario 2: Stock price hovers around $20. You are still OTM. The option will expire worthless and you will keep the premium. You keep the stock and can write another contract for the next month out at the 22.5 again or at the 20 strike if you want to try and collect a higher premium.

Scenario 3: The stock rises to $22.5. You are now ATM and could have to deliver the stock if the stock price rises slightly above $22.5. In this situation, though, you bought the shares at $20 and have gained $2.50 on the stock as well as the premium collected. If you want to hold on to the stock and not get assigned, you can buy back the 22.5 strike price and write out another option at the 25 strike price for the current month or the next month out. If you do this, you will not get assigned at expiration, but you will pay more to buy back the 22.5 than you will collect on the new 25 strike; how-ever, you still have the $2.50 profit gain on the stock. Play with the numbers and the calculations. It


might be in your interest to let the option get assigned at the 22.5 strike price for more profit.

There are tools available to help with this management process. One such tool is show in figure 3:

This tool shows each of the cov-ered call positions as one entity. Both the stock and the option are shown together as one trans-

action. Many brokers show the stocks on one page and options on another page, but with cov-ered calls the stock and option are linked together and are better shown as a covered call or buy-write position. In this example, there are three covered call posi-tions and one long stock position waiting to be turned into a cov-ered call as soon as we sell the

option secured by those shares. This view shows the liquidation value of the portfolio at some point in time. There is a time stamp in the lower left hand part of the display.

In order to and manage each posi-tion, one can click the more info button on the left of each entry to analyze that individual position.

Figure 3




Clicking on the more info but-ton next to the stock “A” (Agilent Tech.) would show a more detailed analysis of that position (figure 4).

In the top section, the current sta-tus of the position is shown with the current price of both the stock and the option. Notice that there is only 0.9% time value left in this position with 10 days left to expi-ration. As we mentioned in the previous section, when the time value goes under 1%, it generally needs some action to be taken. In this case, we should consider either liquidating the position with a nice profit or rolling up to the next higher strike price.

But, let us continue on with the remaining part of the report. In the lower section there are three valuations calculated:

1. Original Position Value

2. Current Position Value

3. Future Expiration Value

The original position value shows the effective cost of the position

Figure 4




after we paid for the stock and received the income for the cov-ered call. Our effective cost is reduced by the income from writ-ing the option.

The Current Liquidation Value shows how much we would receive if the entire position was liquidated right now. Our option would be bought back at the asked price, and the stock would be sold at the market price. In this case we would make $830 in profit or a 5.1% return after we held the posi-tion for 47 days.

The next calculation is another indication that some action should be taken with this position. Taking the ratio of the liquidation profit to the expiration profit shows that we have already realized 83% of the maximum gain possible for the position. Following the old 80/20 rule, it is probably not worth risking 80% of the gains already achieved for the additional 20% in the position. So again, we would conclude that we should liquidate or roll the position up to the next higher strike price. The May 35

Call would pay about $1.00 (or $500) and provide some additional downside protection and some increased income by rolling out to the next month.

The future expiration value shows how the position would fair if the present price of the stock

remained the same to expiration. It shows that we could make an additional $170 if we just waited until expiration without taking any further action. Our return would be 6.1% at expiration.

We also mentioned that it was important to diversify your stock

holdings into different industries. A typical tool to measure your level of diversification would look like figure 5:

A management tool like this pro-vides a very quick means of evalu-ating each position to see if any actions are needed to enhance

Figure 5




returns and measure your degree of diversification.

There are many good references available. To learn more and develop the skills to become an effective covered call writer and generate some real retirement income try some of these refer-ences developed by the author:

• Covered Calls Aggressive Strategy for the Conservative Investor—is a home study course. Details can be seen at http://www.poweropt.com/ccoffer.asp

• There are several books on the subject located at http://www.poweropt.com/educationlinks.asp and one of the best and easiest to read is, New Insights on Covered Call Writing by Rick Lehman and Lawrence McMillan

• Once you understand the basic technique of writing covered calls, you will need a tool to help you find opportunities; go to http://www.poweropt.com, for a search engine to help you find, analyze, and manage your cov-ered calls.



http://www.poweropt.com/educationlinks.asp




traders' guide to increasing retirement income with options

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