Making Money with Covered Calls

By Jeff Carter


 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 


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Covered call writing is the most elementary and conservative of all option strategies. 

It is so conservative that it is the only option strategy allowed in retirement accounts.

The best way to look at covered call writing is to look at the options market as a business. 

The objective of your covered call business is to produce a monthly cash flow. The merchandise with which you run your business are the stocks you hold in your investment portfolio.

If you own common stock, you should be involved in the business of covered call writing. If you are not, you are letting your inventory go to waste. 

You are not opening your store for business. For example, when you own rental property, you rent it. If you own a bookstore, you sell books. The same analogy can be made to the stock market.

The major advantage of covered call writing as an investment strategy is that it is far safer than just owning stocks or mutual funds. 

You generate an immediate cash return on your stock holdings, and the income (option premium) you receive offsets possible declines in the stock price.

For example, in August 2002 we recommended buying 100 shares of Cisco Systems stock (CSCO) at 13.1, and then selling (writing) a CSCO Jan 15 Call for an option premium of 1.4 against the stock position. 

The option premium provided an immediate 10% return for a 5-month holding period. It would also offset a 10% decline in the stock price. And it provided a possible 25% total return.

There are two primary disadvantages with covered call writing. One, your downside risk is only reduced, not eliminated. 

And two, your profit potential is limited. A covered call requires you to sell the stock at the strike price, regardless of how high the stock might have rise. In our Cisco example, we eventually had to sell the stock at 15 even though the stock was at 17 when the covered call expired.

Getting Started
Option writing is not as easy at it sounds. There are many decisions you have to make, and reducing those decisions to a couple underlying objectives is a good idea. Those objectives are to 1) Maximize income, and 2) Minimize portfolio risk. To achieve these objectives you should attempt to generate covered call returns of 20% annually.

The most important decision you'll have with your covered call business is selecting the right stocks to buy. This of course is the quest of investors everywhere. But as they pertain to covered call writing, here are some guidelines for stock selection:

1) Select stocks with high volatility. Higher volatility leads to higher option premiums and more income generation. Options on volatile stocks also tend to have better liquidity, which could help you secure better option prices.

2) Select stocks that are in an uptrend. Just as important, sell stocks that are in a downtrend. Owning stocks is a bullish investment strategy, and writing covered calls does not change a bearish stock to a bullish one.

3) Favor low-priced stocks over high-priced ones. Stocks priced at $10 to $20 per share have a tendency to have higher option premiums per stock value. Also, if you purchase 1,000 shares of a 10-dollar stock as opposed to buying 100 shares of a 100-dollar stock, from a commissions standpoint you are working with 10 options as opposed to just one.

4) If your covered call is assigned, let the stock go. You will be selling the stock for a profit. Then you can step back and decide whether it is worth buying again.

Following these guidelines and with some active management when necessary, you should be able to increase your stock returns by up to 30% annually, and reduce your risk at the same time.

For more information about covered call writing and other profitable options strategies click here.

 

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