How to Sell Covered Call Options

Using a covered call option trading system is a strategy where investors write option contracts for stocks in which they own shares of. The word “covered” means that you own the shares and are able to deliver them to the buyer in the event the contract is called. The other type of option contract is referred to as “naked”, which means that you do not own the stock for which the option contract(s) you initiated. This is one of the most commonly used strategies when combining stocks and options trading. When someone initiates a covered call contract, they typically are long on the stock but feel the short-term price action will remain constant or turn negative. This strategy is often used to hedge against downside pressure in the overall market as well as the individual stock. It is also a strategy used to generate streams of income and is viewed by some as a residual income opportunity.

Using a combination of writing covered call option contracts with receiving dividend payments from a high yielding stock can provide the best of two worlds. If the option trading system is implemented correctly and the stocks used are screened correctly, an investor can generate short-term income streams along with long-term capital gains to maximize their portfolio. Covered call option contracts are typically viewed as a conservative investment because the risks have been reduced. As long as you are purchasing high quality stocks that you don’t mind owning long-term, then this is a unique and sound strategy.

Selling a covered call contract obligates you to sell the stock at the strike price to the buyer in the event they exercise the option(s). Because the seller has this obligation, they are rewarded with the premium paid by the buyer for this contract. This is where an investor can pick up some additional streams of income over time. As long as the rules of the strategy are followed and there is not a huge short-term run-up in the stock, this strategy can help the average investor.

The following steps offer a quick reference in how-to sell a covered call contract. This is by no means a recommendation and it is advised that you test out this strategy prior to you investing your hard earned income. It is also best to complete your due diligence when selecting stocks for this purpose.

Difficulty: Moderately Challenging

Instructions

Things You'll Need:

• Stock Broker
• Computer
• Internet Access

1. 
   Identify the Asset

   Identify the asset - Selecting the best stock to write contracts against can be the most difficult step in the entire covered call option trading system process. Selecting the incorrect asset compared to your level of acceptable risk can be detrimental to this strategy. It is important to screen your stocks very carefully, looking at the underlying fundamentals, market trends, and ongoing options activity. Stocks that have very low options activity will not work for this system. On the other hand, stocks that have very high activity tend to be more volatile and riskier. That is why it is important to screen your stocks to fit with your acceptable risk.
   
   Another important item to keep in mind is that 1 options contract = 100 shares of stock. So purchasing less than 100 shares of a stock will not work with this strategy. In addition, you also need to look at the future options contracts available to determine if even purchasing 100 shares of stock will return any additional income. For example, you may purchase 100 shares of a stock but the available contracts will only net $.05 - $.10 per contract. This scenario in most cases is not worth the effort, as you will probably pay more in commission than you return on your sale.
   
   I prefer to select high yielding stocks that pay dividends. This helps to lower your risk even more as you can receive an income stream from selling the covered call contracts along with receiving income from the dividends. Setting up a DRIP account with your brokerage will allow you to reinvest any dividend payments back into the stock with no commission fees.

2. 
   Purchase Stock

   Purchase stock - Once you have identified the stock(s) you plan on selling covered calls against, you will want to purchase the asset in 100 share increments. You may even already own shares of this stock. The important point is that in order to sell covered calls, you must own 100 share increments. The more 100 share increments you own, the more return you will gain. Also keep in mind that if the stock has a significant increase in value in a short period of time, you may lose the stock. This should be factored into your decision process. Can you live with losing the stock? If you can’t, then don’t sell any contracts against it!

3. 
   Identify Option Contract

   Identify covered call contracts to sell - Once you own at least 100 shares of the asset, it is time to screen the call options on the stock that you would like to sell. This can vary depending on your own strategy and the stock that you have chosen to work with. Some of the more popular and established stocks have contracts available each and every month, while other stocks may have several months in between contracts.
   
   Depending on the available contracts for the stock, you must determine your strategy on how many months you want to sell the contract for. Typically, the more months out the contracts are, the more income you will receive. However, you must consider the number of months and average out the return per month when comparing it to shorter contracts. I prefer to sell covered call contracts on a monthly basis when available. This allows me to consider short-term corrections in the stock market and does not tie me down to multiple month contracts.

4. 
   Sell Covered Call Contract

   Sell the contract(s) - Once you have completed the steps outlined above, you are now ready to place your trade for selling the covered call contract(s). You trade these contracts the same way you would buy and sell stock. I prefer to set limits but in some very rare cases a market order may offer more benefits. For example, some brokers only allow limit trades in increments of $.05 and $.10. In some situations, you may want to sell a contract for an amount that is not in one of these increments. A market order will allow this transaction to be made.

Tips & Warnings

• Research options and stocks on a financial site like Yahoo! before making any trades!
• You must be approved to trade options prior to implementing step #4. Check with your broker on how to set this up and what information you need to have available.
• The following list takes into assumption that you have a basic understanding of how options work. This list is not for beginners to the stock market or for anyone with limited options experience or understanding.

Resources

• Stock Trading Strategies

[mamerten]

on 1/2/2009 This is a great article. Covered Calls has it's known disadvantages which the author points out very well. But a well disciplined covered call trading strategy can be very profitable and will beat stocks in all but the strongest bull markets. Also, any covered call trader will need some sort of tool to help him make decisions on when to manipulate his positions. A great tool can be downloaded at
http://www.coveredcallcalculator.net

[chasingthebull]

on 12/6/2008 Writing covered calls is a great technique to use in sideways or slightly rising markets. I have used them in the past with tremendous success. Great article! 5*s