Appendix C – Covered Calls: A Case Study

The purpose of this covered call (buy-write) strategy case study is to compare the results of
naked stock ownership versus the ownership of stock with calls written against it over time.

The rationale of this study was to see if the premiums collected from the sale of these calls either
enhanced the positive return above the naked stock position and/or provided downside
protection, preventing a loss equal to the loss incurred by the naked stock during an adverse
movement.

For purposes of the study, certain rules were followed to ensure that the study was not
contaminated with any type of outside influence such as position adjustment or discretion.
These types of results are guaranteed by creating constants. The constants in this study will be:

1. Calls will be sold in a 1 to 1 ratio with the stock (one call per every 100 shares) each and
every month.

2. The option that will be sold will be at-the-money strike for each and every month.

3. The stock must be retained every month.

With these three rules, we assured that no expertise involving discretion, timing, or selection
would be made. This guarantees that the strategy itself and not the trained or professional use
of it is being measured.

The numbers are real numbers. All stock prices are closing prices taken from either the NYSE or
the OTC. Option prices were taken from the OCC.

The numbers presented are simply results. The stock results are the price where the stock started
at the beginning of the study versus the price at the end of the study.

The option results were calculated as follows: First, the numbers posted are results in terms of the
profit or loss of the option for the given month. This number was calculated by finding the
difference between the opening price of the option on the day after expiration from the
previous month and the closing price of the option at its expiration one month later.

After the second month, if the stock price was lower than the call’s strike price the option was
out-of-the money and worthless. This meant the entire price of the option was captured as a
positive premium and is represented by a positive number. If the stock price finished above the
call’s strike price, than there were two potential calculations applied.

The first possibility was if the stock price closed above the strike price by less than the amount of
premium acquired in the sale of the option (the premium was greater than the amount by
which the stock price exceeded the strike price).

In that case the option still made money but the stock would be called away. As per the rules,
the stock would have to be retained so the profit of the option was reduced by the amount of
the stock’s price exceeding the strike price. This offset the loss of the stock’s retention cost. It
was still represented by a positive number but a lower one.

The second scenario was if the stock price exceeded the strike price of the call by more than
the amount of premium received from the call’s sale. In that scenario, in order to retain the
stock, the call (in theory) would have to be bought back at a loss. This loss is represented by a
negative number. This negative number (loss) allowed for the retention of the stock in keeping
with the rules.

By calculating the results this way, the stock’s capital loss or appreciation can be isolated in both
the naked strategy and the covered call strategy. This allows the actual premiums received to
be separated from capital loss or appreciation for comparison purposes.

The stock’s starting price is listed along with the finishing price and the percentage return. Also,
each month’s option premium is listed and later totaled.

From there the option return is added to the stock return to get a covered call return. This is then
used to adjust the overall return and finally is compared to the return of the stock only strategy.

Please take note that when looking at each stock’s option premium return over the span of the
months in the study, there are only two or three months that show an option premium with a
negative number.

These negatives are not losses. They represent times of lost opportunity cost because in that
month, the stock traded at about the option break-even point and your stock was called away
from you. The negative number is the difference between where your breakeven was and
where you needed to buy it back in order to retain the stock.

This negative number is not lost money, just lost opportunity. For the purpose of showing how the
strategy worked over the period of time selected, we needed to force the retention of the stock.

Also, the results are tabulated with no lean, just a plain, vanilla sell the at-the-money-call
example of how the strategy works without any outside influence – just straight numbers. In
each case, with different stocks in different industries, the buy-write strategy out performed the
stock only strategy.
Bristol Myers Squib (BMY)

STOCK ONLY RESULTS

Start $23.89
Finish $26.36

+$2.47 increase is a 10.34% return

MONTHLY OPTION PREMIUM RESULTS

10/18/02 +.80
11/15/02 +1.10
12/20/02 +.05
01/17/03 +1.20
02/21/03 +.45
03/21/03 +.62
04/18/03 -2.47
05/16/03 -2.24
06/20/03 +.50
07/18/03 +.45
08/15/03 +1.00

TOTAL OPTION PREMIUM RECEIVED +1.46

STOCK RESULT PLUS OPTION PREMIUM RESULT +3.93

+$3.93 increase is a 16.45% return

Cisco Corp (CSCO)

STOCK ONLY RESULTS

Start $10.53
Finish $17.79

+$7.26 increase is a 68.95% return

MONTHLY OPTION PREMIUM RESULTS

10/18/02 -1.28
11/15/02 +.50
12/20/02 +.20
01/17/03 +.50
02/21/03 +.60
03/21/03 +.30
04/18/03 -1.33
05/16/03 -.13
06/20/03 +.51
07/18/03 +.66
08/15/03 +.15

TOTAL OPTION PREMIUM RECEIVED +.68

STOCK RESULT PLUS OPTION PREMIUM RESULT +7.94

+$7.94 increase is a 75.54% return

 Oracle Corp (ORCL)
STOCK ONLY RESULTS

Start $9.49
Finish $12.30

+$2.81 increase is a 29.61% return

MONTHLY OPTION PREMIUM RESULTS

10/18/02 -.30
11/15/02 +.20
12/20/02 +.20
01/17/03 +.35
02/21/03 +.65
03/21/03 +.25
04/18/03 +.24
05/16/03 +.18
06/20/03 +.80
07/18/03 +.35
08/15/03 +.55

TOTAL OPTION PREMIUM RECEIVED +3.46

STOCK RESULT PLUS OPTION PREMIUM RESULT +6.27

+$6.27 increase is a 66.06% return

 Bank One (ONE)

STOCK ONLY RESULTS

Start $38.88
Finish $39.58

+$.70 increase is a 1.8% return

MONTHLY OPTION PREMIUM RESULTS

10/18/02 +1.35
11/15/02 +.85
12/20/02 +.05
01/17/03 +.65
02/21/03 +.70
03/21/03 +.95
04/18/03 -1.62
05/16/03 +.46
06/20/03 +.25
07/18/03 +.85
08/15/03 +.80

TOTAL OPTION PREMIUM RECEIVED +5.29

STOCK RESULT PLUS OPTION PREMIUM RESULT +5.99

+$5.99 increase is a 15.40% return

 Affymetrix Co (AFFX)

STOCK ONLY RESULTS

Start $23.99
Finish $22.49

-$1.50 decrease is a 6.25% loss

MONTHLY OPTION PREMIUM RESULTS

10/18/02 -.47
11/15/02 +.85
12/20/02 +1.25
01/17/03 +.52
02/21/03 -.87
03/21/03 +.80
04/18/03 -2.53
05/16/03 +.67
06/20/03 +1.00
07/18/03 +1.15
08/15/03 +1.25

TOTAL OPTION PREMIUM RECEIVED +3.62

STOCK RESULT PLUS OPTION PREMIUM RESULT +2.12

+$2.12 increase is a 11.31% return

 COMPARISON

BMY

Stock Alone Return +10.43% Return

With Option Strategy +16.45% Return

CSCO

Stock Alone Return +68.95% Return

With Option Strategy +75.40% Return

ORCL

Stock Alone Return +29.61% Return

With Option Strategy +66.06% Return

ONE

Stock Alone Return +1.81% Return

With Option Strategy +15.41% Return

AFFX

Stock Alone Return -6.25% Return

With Option Strategy +8.83% Return

In each situation, across a range of stocks in different scenarios, the results show that the buy-
write strategy works a high percentage of the time. Please note that the increase in the rate of
return is only half of the story.

During the life of the position, the accumulated premiums received provide a protective cushion
against adverse stock movement. Covered call writing is not always profitable and will not work
every time. Choosing the right option to write against which stock, and when, are critical
elements in determining consistent returns and long term success.

CONCLUSION

The results of the covered call (buy-write) study show that this strategy can be successful across
a wide range of stocks and across a wide range of variables and trading patterns: A closer look
at the study hammers home some interesting points.

First, when looking at the monthly option profit and loss figures, we see that the option made
money in 8 or 9 out of the 12 months on each of the five stocks. This seems to confirm the studies
that stated that the sale of premium was the right trade about 80% of the time.
Second, the strategy worked in the stock that was down, the stocks that were stagnant and
even in a stock that was up big.

Third, the strategy seemed to provide equal returns for higher volatility stocks as well as lower
volatility stocks. These numbers and stats show that the covered call strategy does work. The
following charts will show why and how the strategy worked in the case studies.

Bristol Myers Squibb (BMY) Weekly Chart

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Notes

Stock: Bristol Myers Squibb Symbol: BMY

The BMY chart shows a stock that had some bad news back in March/April 2002, traded down in
distressed asset fashion, until reaching a level of exhaustion in July/August 2002.

After that, the stock consolidated into a new trading range as shown by the two colored boxes
connected by the straight solid line. Our study was conducted during this period of time and
was as successful as it was because it was conducted at this particular time.

From October 2002 to October 2003, BMY’s trading range tightened. Take notice of the moving
average line marked MA starting around April 2003 through October 2003. The line is almost
perfectly flat for 6 whole months. This shows a real lack of movement.

For a six month period, this stock barely had a pulse. A buy-writer can’t ask for much more than
that. Not only did it tighten from a monthly and weekly perspective but also daily and further
intra-day.

This intra-day range decrease can be seen by the length of each daily vertical line. The
shortening of each individual line indicates a continuing smaller and smaller daily trading range.

Although this indicates a decreasing volatility which in turn indicates a smaller premium, it also
indicates a better chance at capturing that premium and doing so on a more consistent basis.

This buy-write was a winner due to the consolidating nature of the stock and the fact that soon
after its decline, the stock had a long period when the trading range tightened.

Cisco Systems (CSCO) Weekly Chart

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Notes
Stock: Cisco Symbol: CSCO

Chart 2, the Cisco chart, is much different than the Bank One chart. The moving average line
(marked MA) has much more bend to it. It is not nearly as flattened out as the Bank One
moving average. This stock is not stagnant.

Also, there does not seen to be much grouping. Although there are apparently no similarities,
the covered call writing strategy works in this situation also. Again, I would like to call your
attention to 2 separate points.

First, notice the two boxes at either end of the graph with the line connecting the two boxes.
Notice how straight the line is between the two boxes. This indicates that the stock’s starting
price and ending price are almost the same.

During this two year span the stock’s value did not change much at all. The stock did fluctuate
during the 2 year span in between the starting price and ending price but there was little
difference from start to finish. So, we see little movement from start to finish but some movement
in between. The lack of movement of the start to the finish could be a good sign for covered
call writing if the in between is not too volatile.

The second point deals with the area between the beginning and the end. As you can see, the
stock starts out in a downtrend, bottoms out just before October of 2002, and then starts into an
uptrend that extends into November 2003.

There is no real grouping to be found but there is another pattern. In the uptrend, there is a slow,
gradual upward ‘step’ movement. No major advances, just a slow, constant one small step at a
time movement. This movement is visible on the downside as well but not as prevalent as the
upward recovering movement.

There, the step by step upward movement is the slow, gradual, low volatility directional move
that serves covered call writers well.

So, in this case, CSCO is stagnant from beginning to end, with low volatility directional
movement in between. Even though the movement is significant between the start and finish, it
is directional and mostly of low volatility. This combination bodes well for covered call writing.

Oracle Corp (ORCL) Weekly Chart

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Notes

Stock: ORACLE Symbol:

ORCL
Looking at the Oracle chart, we can see the reason why the buy-write strategy had such
success from Nov 2002 to Oct 2003. Turn your attention to box 2.

Box 2 is located roughly around the time the study was started. From a price standpoint, the
center of the box is around $12.00. From this time all the way out to Oct 2003, the stock is in a
consistent sideways trading channel. The channel seems to have a low of about $11.00 and a
high of about $14.00. Further, the line drawn from box 2 to box 3 is almost totally flat at roughly
the $12.50 level.

The stock travels up above the $12.50 range to about $14.00 then travels down through $12.50 to
about $11.00 and then back up again. These moves are slow, smooth movements both up and
down.

These types of moves are of a consolidating nature and are of a decreasing volatility. This chart
shows a good buy-write opportunity.

As this pattern continues toward September 2003, we notice that the stock starts to show higher
lows and lower highs. This shows that the stock’s range is tightening and the stock is headed
toward a stagnant phase.

Further, go back to October 2002 and pay close attention to the actual length of the vertical
lines that signify the intra day range of the stock. Now, if you scan forward in time toward
October 2003, you see that the average length of the daily range (vertical) lines get shorter.

This indicates that the stock’s daily movements are decreasing and that the stock is not moving
around much. This pattern indicates a decreasing volatility and a stagnating stock. It confirms
the pattern we were seeing with the tightening trading range. Again, this is a good candidate
for using the buy-writing strategy.

Bank One (ONE) Weekly Chart

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Notes

Stock: Bank One Symbol: ONE

The chart of Bank One shows two very notable patterns that can be successful to covered call
writers.

The first is the moving average line. It is the horizontal line stretching across the chart outlined in
yellow and marked MA. The moving average is an indicator that shows the average value of a
securities price over a period of time.

As you can see, the line is basically flat considering the chart covers roughly a two year term.
The flatness of this line indicates the stock’s actual volatility was low and the stock’s movement
was stagnant. A stagnant stock scenario, as we know, is a favorable covered call writing
situation.

The second is a situation that I will call grouping. On the chart, you will see several orange boxes
that encase several consolidations. These consolidations are time groups ranging from several
weeks to a few months of relative stagnation.

Look at the first box marked 1. This period of time covers approximately 3 months and the stock
had a two dollar range.

Box 2 also has a stock range of about two dollars but the approximate time period is closer to
five months.

As you can see, those boxed “groupings” constitute a very large part of the stocks movements
during the 2 year period. These large periods of stagnant time allow for very successful covered
call writing.

Affymetrix (AFFX) Weekly Chart

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Notes

Stock: Affymetrix Symbol: AFFX

Unlike our previous four examples, the stock price of Affymetrix was actually down during the
period the study was conducted.

Due to a negative news story, AFFX had a day where the stock dropped over $10.00 from
around $27.00 to a price of $17.00. The stock did recover but still finished the period down 6%.
AFFX is a perfect example of how the collection of premiums over time can offset small or even
moderate losses.

The AFFX covered call write works for different reasons than the previous examples. Looking at
the chart we recognize a familiar pattern. The moving average line, which is relatively flat, is
normally a good sign for potential covered call writing.

The problem is that the stock’s range off the moving average line is quite substantial in both
directions. The movements are large and fast signaling higher volatility levels. Comparing the
daily movement vertical lines to previous examples you see how this stock has bigger daily
moves in addition to an overall wider trading range.

The success of this covered call is a combination of two factors. The first and foremost is the size
of the premiums.

The option premiums were much higher because of this stock’s high volatility. The larger
premiums gave us an extra protective cushion and we needed it.

From looking at the chart, you can tell that this stock was all over the place. The bigger
premiums were a help but they needed to be combined with another factor which caused the
strategy to be successful . . . luck.

We were lucky enough that the stock was able to finish the period in question somewhat close
to where it had started. During the period, the stock saw a high of over $27.00 and a low
around $17.00. Since we were blessed with a stock loss of only a couple dollars, the premiums
were able to offset that loss and even provide us with a reasonable gain.

While our other examples show the covered call’s ability to augment gains, this example shows
the covered call’s ability to provide downside protection from adverse stock movement.

This illustrates how the covered call strategy can be used as a defensive measure, as well as for
profit enhancement.