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For many investors, the covered call may be their first encounter with options. This strategy can generate monthly cash into your account. A covered call is one of the simplest and widely used option strategies. Let's take a look at what makes up a covered call.
The covered call strategy consists of buying stock and simultaneously selling calls, also called writing, on a share for share basis. You may also sell calls on stock that you already own as long as they are optionable. If you are not writing calls on your core holdings, you are leaving money on the table. Call writing does limit your upside potential. You are giving the owner of the call the right to call away your stock at a fixed price (strike price) for a specific period of time. The option buyer pays the covered call writer a premium for the right, not the obligation, to buy the shares on or before the expiration date. The expiration is the Saturday following the third Friday of the month. The premium received can be considered a supplement to the dividend income from the underlying stock (if it pays one).
Step 1:

Stock selection. This is a neutral to bullish strategy. I prefer dividend-paying stocks. You want to stay away from stocks that have high volatility because the risk is in the stock. You can also use the dividends to help purchase protective puts when the market is bearish.

Let's use this example: ABC stock Trading at $32.14 a share with two weeks to expiration. We purchase 1000 shares.

Step 2:

Determine which calls to write. Yahoo finance provides information on stocks as well as calls and puts for free. In our example, we find the 35 calls are trading at $1.10 and the $37.50 calls are trading at $.59. We believe that our ABC stock will not be over $35 in the next two weeks. (Remember options expire Saturday after the third Friday each month). We write the 35 calls and collect $1.10. Each option contract equals 100 shares of the underlying stock, so we want to sell 10 contracts and collect $1100.00.

Step 3:

Lets calculate the return:

Call price ($1.10) plus dividends ($0.00) equals $1.10

Divided by stock price $32.14 equals 3.4% of income.

Times 365/14 days to expiration.

Equals annualized return (88.63% before commission)

Covered call writing is a good way to increase returns in a stable market and reduce stock price risk. Know the risk in any trade and have a plan for every outcome before you initiate the position and remember early assignment is possible. Covered call writing is appropriate for a neutral to bullish strategy and can be done in a cash, IRA, Keogh or margin account. Good luck and happy investing!

 

Useful Links:
Yahoo Finance

Comments

Good article on the basics of covered calls. Selling calls is a great way to add some extra income to your portfolio.

By Travis Engebretsen 13 weeks 6 days