How to Sell Stocks Using Covered Call Options

Using covered calls combined with limit sell to open orders is a good way to enforce the discipline of selling positions that has met your selling criteria and derive a little income as well. It is a nice income-generating alternative to using trailing stops or simple limit orders on the stocks.

Difficulty: Challenging

Instructions

Things You'll Need:

• Broker account
• A stock position in round lots (100, 200, ... )

1. First you must get your account approved for options trading by your broker. This typically requires you to fill out a form similar to when you opened your trading account, but shorter, maybe a page or two with stated income and stated options experience (0 years is generally okay, everybody has to start somewhere).

2. Determine your selling price. If you manage your own portfolio, you should have rules that determine your selling point. These could be based on P/E, yields, quick ratios, analyst research, etc. Regardless, there should be a specific number, like $21.50.

3. Determine whether options trade from your particular company. This is not always the case, particularly not for thinly traded units or small cap companies with a capitalization less than $100 million. If you log into your trading account and click on your company, there should be an options option (pardon the pun); click on that.

4. Find out what the options premium for call options is around the money. For instance, if your stock from the example above is trading at $14 and the one-month premium for a call with a $15 strike price is $0.30, use that as a reference.

5. If you are going to sell your $14 stock at $21.5, note that there are probably not options with strike prices specifically for $21.5. Maybe there's an option with a strike at $20 or one at $22.5. Let's pick the one at $20. Now determine what you should ask for it. You wanted to sell for $21.5, so you should demand at least $1.50, which would make your total proceeds $1.5 for the option plus $20 for the stock when it is called. However, you should also add the time premium.

6. To determine the time premium, use $0.30 from above, but realize that this was in relation to at strike at $15 when the stock was trading at $14. Therefore, you need to scale the number. $20/$15 is 4/3, so multiply that with $0.30. This means that all other things being equal, the time premium should now be $0.40.

7. Add $0.40 to $1.50 and get $1.90. This means you should sell or "write" your call options for $1.90.

8. Put in a limit order to "sell to open" at $1.90 and wait. Once triggered, your stock will eventually sell itself and you do not have to second-guess yourself or be tempted to move your sell-price because everything is on auto-pilot.

Tips & Warnings

• For more time premium, sell several months out.
• If the stock does not meet your sell price in time, you keep the stock AND the premium.
• If the stock rallies far past your selling point, the time premium will drop. You could then buy back your calls and sell the stock. This will result in a little bit of time premium, but of course you will not get the money from the rally.
• Once you sell a covered call on a position, dividends may no longer be qualified. This will complicate your taxes slightly.

[edwardvance]

on 11/11/2009 Great article on covered calls. Super writing and well laid out tips. 5* and I recommend.