Buying to close covered call positions …

About three months ago, I wrote a Money and Markets column that said I was going to start helping my dad generate more income from his dividend stocks by writing covered call options against them. And since we just closed out our first two positions using a special approach that I have not discussed here before, I wanted to give you an update on how things played out.

But before I do, let me first remind you what covered call writing is all about …

When you write an option you are selling another investor the right to buy shares from you (in the case of calls) or sell shares to you (in the case of puts) at a predetermined price. And as with most contracts, there is a timeframe involved. Meanwhile, as the person selling the contract you collect an upfront payment, known as a premium.

Like I always point out, it is entirely possible to sell calls without owning the underlying stock, but that strategy is only appropriate for the most aggressive investors — and it carries substantial risk of loss.

In contrast, covered call writing is quite conservative because you are only committing to sell shares that you already own. Better yet, you always know well in advance what all the potential outcomes are.

Now Let Me Show You a Trade that Dad Just Completed
So You Can See How This All Works for Yourself …

I initially recommended 200 shares of Pfizer to Dad back in October of 2010, and he purchased them for his $100,000 IRA account at $17.39 each.

Since then, the stock has done quite well — rising more than 25 percent. In addition, he has collected another 10 percent or so in dividend payments!

However, Pfizer’s shares were trading close to $22 at the end of last month, an area that has historically represented a major ceiling for the stock. Moreover, the broad market also looked to have less upside going forward given the strong start to the year.

So I told Dad — and my Income Superstars subscribers — that it looked like a good time to write some options on the Pfizer position. My specific recommendation? Aim to write two $22 April 21st contracts on Pfizer. (Remember, one contract covers 100 shares of stock.) And I also specified a minimum amount of premium that Dad was to accept for each contract.

With these instructions, Dad was able to collect $149.99 in premium after his initial commissions were paid. The trade happened on March 30th and Pfizer was trading a bit above the $22 strike price at the time, so technically Dad wrote “in the money” options.

Now, after this initial order was filled here are all the various things that could have happened:

A. Pfizer could have stayed above $22, and at some point the holder of Dad’s contracts could have exercised them.

Under this scenario Dad would have kept his premium, all those dividends he collected during the holding period, and — based on the $22 strike price — he would have locked in an overall capital gain of about 26.5 percent (before the exit commission was paid).

B. The same as above, only the contract holder could have decided it wasn’t worth exercising the options even if they were in the money.

This will often happen when the options are just slightly in the money, or the contract holder is using the option as part of some larger strategy.

However, it is worth noting that most brokerage houses will automatically exercise in-the-money options contracts before expiration — typically once they’re in the money by even a few cents — unless they’re told otherwise by the client.

C. Pfizer could have fallen to $22 or below and stayed there the whole time after Dad wrote the contract.

Under either B. or C., the result is the same: Dad would have kept his shares, the dividends, and the premium. And once the options expired, he would have been free to write new contracts to collect more premium. In my mind, this is the outcome we want for a conservative income portfolio.

In Actuality, NONE of the Above Happened …
Because We Used Another Technique
That I Have NOT Discussed Here Before!

Previously, whenever I have discussed the possible outcomes of covered call writing, the scenarios above are the ones I have mentioned.

And make no mistake: They DO represent all the possibilities if you as the contract seller don’t take any additional actions during the life of the contract.

However, there IS something else that you can do to close out the trade ahead of time. It’s called “buying to close” and here’s how it works:

At any point before the call you wrote is exercised, you can go out and buy the exact same call yourself. In doing so, you have effectively cancelled out the contract you initially wrote!

Why (or when) would you do this? Typically you would do it to lock in a profit on the premium you’ve already collected ahead of the regular expiration date.

In the case of Pfizer, I saw that the shares had pulled back below $22. That fact, along with the natural erosion in premium because less time was left on the contract, meant that Dad should have been able to buy back the same options contract for a lot less than he had originally sold it for. Better yet, by doing so, he wouldn’t have any risk that another run-up in the shares would cause him to lose his underlying position in Pfizer.

So, that’s what I told him to do. And based on my recommendation, he closed out his position on April 16th — about a week ahead of schedule.

The price he paid for the same contracts he originally wrote for $149.99? A mere $28 (again, including commissions)!

In other words, Dad was able to lock in a total profit of $121.99 in three weeks. Based on his underlying investment in Pfizer, that represents a 3.5 percent return on his investment … or 60.7 percent annualized!

Basically, Dad earned a lot more on this one three-week covered call trade than most investors are getting from other income investments during a whole year.

And as a final coda to the story — the decision to close the trade out early was the right one. Because by April 21st, the actual contract expiration day, Pfizer’s shares were way back above $22 again.

Meanwhile, the second covered call trade he closed ended up working out pretty much the exact same way though his profit on that one was “just” 1.4 percent after commissions.

So based on these real-world results, I can tell you that the strategy does have terrific potential to boost a portfolio’s investment income, especially when you actively manage your positions … and we’ll certainly be looking to continue writing more calls in the future.

Best wishes,

Nilus

P.S. If you want to see what recommendations I give Dad next, I encourage you to subscribe to Income Superstars today. Heck, a full year is only $39!