The stagnant scenario

When we apply the covered call strategy to the stagnant stock
scenario, we take a negative return scenario and turn it into a
positive scenario. Remember, when we sell an option, we receive
a premium for doing so.

When the stock does not move during the options life, the
extrinsic value of the option goes to zero. The amount of money
paid for the option goes to the seller. Well take a look at how
this sets up.

Lets go back to our previous example with the stock trading at
exactly $9.50. We sell the front month, at-the-money call, which
would be the 10 strike call. We sell the front month 10 strike
calls at $.50. As time goes by, there is less chance for the
option to become in-the-money. As this happens, the extrinsic
value lessens and finally, after Friday expiration, the option
is worthless.

The stock finishes at $10.00 and you have received no capital
appreciation but you have received the full $.50 of extrinsic
value from the option sale. If the studies are correct and
selling the premium works 80% of the time, then you will collect
approximately $4.00 per contract sold over the course of the
year.

As the examples demonstrate, writing covered calls against a
stagnant stock can provide you with an acceptable return instead
of frustration, wasted time and capital.
The down scenario

In the final scenario, where your stock purchase is headed down
into negative territory, the covered call strategy can help
minimize your losses. Although picking losers and incurring
losses is inescapable, it can be minimized and controlled. Lets
take a look at how the buy-write can help us do that.

For example, lets say you bought a stock for $9.50 and at the
end of the month the stock had traded down to $8.50, you would
have a $1.00 loss on our investment.

However, if you had sold the 10 strike calls for $.50, you would
only have a $.50 loss. You would have a $1.00 capital loss in
the stock, but a $.50 option gain from selling the option, which
would expire worthless.

If you were going to buy the stock anyway and incur a possible
loss, it is better to take a $.50 loss than a $1.00 loss. In
this down scenario, the option premium received helped to offset
the capital loss.

If the stock is down more than the amount you received for
selling the call, then the option premium serves as an offset to
the loss of the stock.

However, you can still make money in the down scenario using
the covered strategy if the stock is only down a small amount.
There is a scenario in the buy-write strategy where you can
profit from owning a stock that is lower than where you bought
it.

Going back to the previous example, you bought a stock for $9.50
and you sold the front month 10 strike calls for $.50. At
expiration, the stock finishes down $.20 at $9.30 You would have
incurred a $.20 loss on your stock.

However, with the stock at $9.30, the 10 strike call that you
sold for $.50 is now worthless. So, you have a $.20 loss on the
stock and a $.50 gain from the option premium sold. This leaves
you with a gain of $.30 on a stock that is down $.20 since the
time you purchased it.

To recap: in our third scenario, the down scenario, your loss
will be offset by the option premium you received so your loss
will not be as severe. You still may incur a loss, but it will
be minimized, and minimizing losses is a key to successful
investing.

For a complete breakdown of these three scenarios, please refer
to the table below.