We had a greatest readership on Tuesday with 80.0% of readers opening the blog at least once in the 24 hours after it was sent. Not sure what was so special about that one, but it did invite a few folk to ask some great questions. A few people liked the simple explanation of the mechanics of a covered call. Just as reminder this is what we said:

"Since we are in a murky situation and a probably stagnant situation with oil, I took advantage of the situation by selling March call options against my long position in the Salve Lucrum.

Now pay attention boys and girls. For every 100 shares of XOM we own we sold one March 17 $87.50 call option for .51 cents a contract. That mean that someone paid me $51.00 for every 100 share I own. The stock is selling for $84.67. I am betting that Exxon will be worth less than $86.99 ($87.50-.51) on March 17th. If it does, I get to keep the 51 cents a contract and keep my stock. If it is worth more than $86.99 it will be called away on March 17th and I keep the profit and the premium, but must sell my stock.

I am looking for these opportunities in all of my long positions in all of my core holdings because I think we are in a one week to two week doldrums period. OPTIONS ARE NOT FOR EVERYONE. KNOW YOUR RISK AND REWARD RATIO BEFORE EXECUTING A COVERED CALL SALE. Call me if you want a better description of what I am doing."

One of our readers, Ron asked a great question:

"Thanks for the explanation of covered call options. You indicate you are looking to do this for all of your core holdings since the market appears to be in the doldrums, for the time being. Let's say, for example, the market really took off (upside) between now and the option expiration date. Does that mean your "core holdings" would then be decimated, as you would have to sell those shares?"

The simple answer would be yes you do risk some gains if there is a huge short term upswing. But you would have gains none the less. Let's take a look at the example we used to describe what we did.

For argument sake, let's say I bought 100 shares of XOM at $84.50 a share on December 22, 2011. After two months, we felt that the stock has been a bit dormant and will be for the next 4-12 weeks. (Now in my book that means less than a 4-5% swing in any direction.) I decided to sell 1 March 17th $87.50 Call option for the 100 shares I own for .50 a contract and I executed that contract on the 14th of February. The stock was roaming around $84.50 on the day I did the contract.

Here is what the trade does for me. It puts 50 dollar in my account because I sold the call for .50 for a 100 share contract. I must sell 100 shares at $87.50 if the owner decided to exercise the call option. Remember they are buying the call option to buy 100 shares of XOM at $87.50 a share on March 17th. In order for that trade to make sense to the buyer, the shares have to sell for 88.00 (87.50 + the .50 for the option) or higher near March 17th. It would not make sense to buy the shares at 88.00 if the stock is selling for less than that. I am betting that XOM will not escalate 4.1% over the next 21 trading days. So best case scenario is the stock goes near 87 and I see a nice unrealized gain in my holding and I get to keep the $50.00 I got for selling the call. That would be $50.00 on an investment of $8,450.00 or .6% for one month or 7.1% a year.

Let's take a look at the worst case scenario. The stock goes to 88.01 on March 17th and the buyer of the call wants to exercise the option. I still keep the 50.00 and I get the profit from my entry point of $84.50 to $87.50 as a realized gain because I HAVE to sell the stock. That would be a realized gain of 350 dollars (300 for the stock and 50 for the option) against the purchase price of $8,450 also known as 4.1% in two months time. I'll do the math for you that is a 24.8% annualized gain.

Now to clarify, I would not do this with all of the core holdings. Each one has to be evaluated. First, does the stock have options? If so are they weekly, monthly or quarterly options? Are they tradable options with lots of volume? You don't want a roach hotel option, easy to get in and hard to get out. What is the spread on the option price? That is the difference between the bid and the ask. Determine how far "out of the money" can you go and still make a decent return. For example I could have sold April call options against XOM for 21 cents and May contract for 9 cents, but the return were not worth the time and effort. Do you have a good feel for where the market is going over the next month? Do you have a good feel for what your stock might do over the next month? You have to answer these questions for each stock.

In summary, the better you know the market and your core holdings the less risk you take in determining if a covered call sale can add to you portfolio value.

Salve Lucrum