Can you tell me a little about options, and in particular covered call options?

Joseph J., a 41-year-old engineer from Burlington, is looking for growth with the $300,000 he has invested. He asks: “Can you tell me a little about options, and in particular covered call options?”

Options are one of the least understood and underrated of all investment vehicles out there, Joe.

While some strategies can be extremely aggressive, covered call options are ultra conservative. Let’s have a look at how they work. Let’s assume a stock is trading at $6, having fallen from last week’s, and the past 52 weeks, high of $6.50. Many analysts have speculated the stock could hit $7 before too long. National Bank analysts, and others, feel this is a possibility, while Nesbitt Burns, Smith Barney, and more, have cut their rating on Nortel to “underperform.” Since the jury’s out, let’s buy the stock at $6.

We see there is a $7 call option available, trading at 60 cents and expiring in 7 months. We are going to sell that call option and bring in the 60 cents. That is our money and we stuff it in our jeans. We paid out $6 and brought in 60 cents. You can see we just earned a quick 10 per cent on our investment.

So what’s the catch? The catch is we just entered into an obligation, which states that at any time in the next 7 months, if someone wants to buy our stock from us at $7, we must sell it to them. Obviously if the stock is trading below $7, no one will buy it from us when they can buy it cheaper on the market. If the stock is trading higher than $7, we may be forced to sell ours at $7. Let’s assume the stock is trading at $7.25 in 7 months and we have to sell ours for $7. We bought it at $6 and sold at $7, plus we also picked up the original 60 cents for gross total profits of $1.60 on our $6 investment. That’s a 26.6 per cent return in 7 months. Not bad. Let’s also look at the stock trading at $6.75 in April. We are up 75 cents on the stock and we pocketed the original 60 cents for profits of $1.35 on our $6 investment, a 22.5 per cent return in 7 months, plus we still own the stock and we can either sell it or do it all over again for another 60 cents. Options are available on many stocks and you can even implement the strategy in your RRSP with less risk than just buying the stock.