How to Generate Income With Covered Call Writing
Covered call writing is buying shares of stock and selling call options against those shares. When successfully used, covered call writing can generate an impressive level of income. Returns of 15 to 20 percent per year or more are possible. This strategy uses tradeable stock options to generate an extra level of income from the purchase of stock shares. Covered call trading is considered to be the least risky form of options trading and can be accomplished in regular or IRA brokerage accounts.
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Instructions
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Apply for an online stock brokerage account with options trading privileges if you do not already have an account. You can also add options trading to an existing stock account. Options trading authorization requires the completion of extra application and financial disclosure documents. "SmartMoney" magazine publishes an annual review and rating of brokers if you need help selecting a broker (see Resources).
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Familiarize yourself with the brokerage account's option chain screen, stock price screen and options calculators. Covered call calculators take the current stock and option prices and calculate the expected return for covered call trades. Use the calculator to compare the expected return of potential covered call trades.
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Select stocks as covered call candidates. Appropriate stocks are expected to have stable to rising share prices over the next several months, have actively trading call options and option prices with enough premium to meet the desired returns. Implied volatility of call options gives an approximation of the expected annual return from writing covered calls. The options used should trade at least several hundred contracts per day.
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Select the call option to provide the income of the covered call trade. On the stock's option price screen you want call options expiring two to three months in the future at the next strike price above the current share price. For example, Caterpillar (CAT) is trading for $101 per share. The next strike price up is $105 and CAT has options expiring in two months at a premium of $2.80.
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Select the covered call strategy from the trading options available on the option pricing screen. The broker's online system should go to a trade screen with the stock price and option information filled in.
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Enter the number of shares to buy and number of stock option contracts to sell. Each option contract is for 100 shares of stock, so the stock purchase will be in multiples of 100. For the example, buy 200 shares of CAT and sell two of the selected call options.
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Note the net debit price and complete the trade if you are satisfied with the share and option pricing. Covered call trades are completed at a net cost or debit. In the example, the cost would be ($101 - $2.80) x 200, or $19,640, plus commissions.
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Monitor the covered call trade until the sold call options expire. If the stock is below the strike price at expiration, you will retain the shares and can sell more call options against those shares. If the stock goes above the strike price, the shares will be called away at the strike price and you can set up another covered call trade with the proceeds.
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Tips & Warnings
Covered call expected returns are calculated for the stock remaining unchanged and if the shares are called away. In the example, if CAT stayed at $101, the return for two months would be 2.85 percent. If CAT climbed above $105 and the shares were called away the two-month return would be 6.92 percent -- commissions not included.
Commissions can have a significant effect on the returns from covered call trading. Find a broker with low commission rates on options.
The worst outcome for covered call trading is a rapidly dropping share price. The options must first be bought back before the shares can be sold. Be prepared to close out a covered call trade quickly if it moves to a losing position.
References
Resources
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