Selling Call Options with long (owned) Stock Shares - Covered Call Writing

Selling or shorting call options that are uncovered is a dangerous strategy in the stock trading markets. Shorting option contracts that are NOT covered requires that a person to deliver (sell) shares of stock to the call holder at a set price. If the writer (seller) does not own the stock, there is an unlimited loss potential - since the stock can rise to an infinite amount.

Owning or long the stock "covers" the option. If the option is exercised, the stock is used to fulfill the obligation on the contract.

Covered Call Strategy Example

Long 100 Shares @$60
Short 1 Feb 65 Call for $300

The Maximum gain, loss and break-even are all tied to the stock performance and the premium received on the option.

The break even is 57. The stock is owned at 60, but the investor received a $300 premium which lowers the overall cost to $5700

The Maximum loss is that total outlay of money. $5700. The $6000 of stock could decline to zero, but the $300 would be retained.

The Maximum gain is the difference between the purchase price and the strike (sell) price on the contract.  That difference is $500 + $300 for the premium received for a total maximum gain of $800.

Calculating Earnings Per Share - EPS Formula Calculation

Earnings per share is the allocation of a company's net income to each outstanding common share of stock. Earnings per share is used by Wall Street & other stock market analysts to measure the profitability of a company versus another company in the same industry, plus is a way of evaluating quarterly financial results of the company. The formula for calculating Earnings per Share is:

EPS = (Net Income - Dividends on Preferred Stock) / Average Outstanding Shares

Average outstanding shares is also known as the Weighted Average number of shares because since a company's outstanding shares on the stock market change all the time, we like to use an average that represents a fair number of shares throughout the year. Some companies use the outstanding number of shares at the end of one period in order to simplify their calculations.

Calculate Earnings per Share

Here's a hypothetical example. ZZZ Corp. has a net income of $50 million for the year ended December 31st, 2010 and has 20 million shares outstanding on the New York Stock Exchange (NYSE). The company does not have any preferred shares outstanding so it does not have to pay out any preferred dividends. What is the Earnings per Share?

EPS = (Net Income - Dividends on Preferred Stock) / Average Outstanding Shares

EPS = ($50 million - $0) / 20 million shares

EPS = $2.50

Analyst Estimates on EPS

Most large cap organizations in the United States have several Wall Street analysts that closely follow the company's earnings and business operations in order to forecast an earnings per share number. Analysts following a company like to issue EPS estimates for for the most recent quarter, the next quarter, the current fiscal year and the next fiscal year. The average of all analysts' estimates are tabulated and a final EPS estimate is released on the financial media. Other information that comes along with EPS estimates is:

i) Number of Analysts - This indicates the number of analysts that have provided estimates for this company and are closely monitoring the business.

ii) High/Low Estimates - This provides estimates of the low end of the EPS versus the high end; generally the closer these estimates are together, the more confident you can be of the earnings estimate.

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Earnings Per Share - Stock Value through EPS

 Earnings Per Share, And Price/Earnings Ratio - Two Tools For Determining Stock Viability

There is far more to owning a stock than its share price, even if it's the share price that gets all the coverage in the financial press. A share price only shows the price to buy the stock, or how much you can theoretically sell it for, but it does little to convey how much value is retained from holding the stock for the long term.

The key to determining long term value in a stock is it's price/earnings ratio. Price/earnings is, in essence, the price of a share, divided by the earnings per share. Earnings per share is calculated by dividing the total profits (less operating expenses, and preferred stock dividends) by the number of outstanding shares in circulation.

When looking at price/earnings ratio, a handy rule of thumb is to try to calculate how many years of earnings would one share have to accumulate to match the price it was originally purchased at. In most companies, this results in a ratio ranging from 10 to 15, with a few undervalued stocks hitting 7 to 8 years. One of the hallmarks of the dot-com boom was the absurdly high price/earnings ratios - some shares of stock were selling at P/E ratios of 100 or more, during the '90s.

One thing to be aware of is that there are multiple ways of calculating earnings per share; they all boil down to set asides of funds that are paid out before earnings are divided up between shares. If you have any questions about how earnings per share are calculated for a stock you hold, ask your broker for more information.

The key to earnings per share is that by holding a share of a company, you are, in theory, holding a piece of a corporation with a retained value, and you aren't speculating on the price going up indefinitely. One method of maximizing a good PE ratio stock with a stable price is to invest in a dividend purchasing plan - in essence, you're telling the company to reinvest your dividends into new shares of the stock.

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Call Option Basics - Long Positions - Buying Contracts Calls on Stocks

 Call Option Trading 

An investor who feels the market will rise on a stock, index, sector or other, may wish to purchase call contract options. 

If SRX Stock is expected to rise (from the investor's point of view), he could purchase a call option will rise in value during it's life if the stock does in fact rise. The value will depend on how high the market rises, and the time left on the contract. All Options have monthly expirations, so time is absolutely part of the strategy, and the risk.

Current market value of SRX is $63. The investor anticipated a jump in price over the next 14 days, but he does not want to spend additional funds to own the shares outright. A cheaper alternative (capital wise) would be to buy call contracts. 

A position scenario could be as the following:

SRX Current Market Value or CMV is $63

Buys 1 SRX SEP 65 Call for a $400 premium per contract.

If SRX begins to increase, the value of the contract will go up. The contract itself allows the buyer to lock in a price of 65 per share until September.  If SRX moves to say $72, the investor can still buy the stock for $65. The contract itself can also be traded. So, if the market doe move to $72, the contract could be worth $1000. The investor could sell the contract and make a profit of $600 from his original investment of $400.  

The risk is the stock remains flat or goes down and the contract expires worthless. The maximum loss would be the $400 invested. The maximum gain is unlimited or unknown for the upside since the owner can lock in a buy price of $63 and the stock could shoot up to anything. The break even is 69. Call (or strike price) of 65 + 4 ($400 premium)