How to Do Covered Calls

Use covered calls to generate steady income from the stock market.

Covered call writing is a conservative strategy to generate income and some capital gains by trading a combination of stocks and call options. Call options are the right to buy the underlying stock at a certain price for a set period of time. Call sellers receive premium for the options and must deliver the stock if the option is exercised by the holder. The secret to a successful covered call strategy is research into specific stocks for covered call writing.

Instructions

1. Select the stocks you will use for covered call writing. The stocks should have a reasonable amount of volatility and have good volume in options trading. The volatility can be determined by the implied volatility of the at-the-money calls. Option volume should be at least 200 contracts per day near the money and bid/ask spreads of 5 cents or less.

2. Calculate the return if the stock is unchanged and the return if called for the covered call combinations you are considering. The call options should be the next strike price above the current share price, one to two months until expiration. Your online broker website will have the option return calculator in the option tools section. Select the most attractive combination or combinations for trading.

3. Enter the order to simultaneously buy the stock and sell the call options. The broker option trading screen will allow the trade to be entered as a net debit to your account. Each option contract is for 100 shares of underlying stock. If the stock is at $54 and the options contract is $2.50, an order could be 200 shares of stock purchased, 2 call option contracts sold at a net debit of $51.50. Use a limit order to ensure it is filled at prices that meet your return goals.

4. Monitor your pending order to ensure it is quickly filled. A covered call order with a reasonable limit price should be filled within 5 to 10 minutes. If not, review the stock and option prices and adjust the limit price of the order.

Tips & Warnings

• Covered call writing works best in a flat to slowly rising market. It should not be used in a rapidly changing market.

• If the stock finishes below the strike price of the call, the options will expire worthless and you can sell more options with a new expiration date.

• If the stock reaches the expiration date above the option strike price, the stock will be called away and you will have the cash in your account on Monday. Do not place a new covered call trade on that Monday. The rest of the covered call world is trading that day, driving down the value of the options. Wait a week before initiating a new covered call trade.

• Use a broker with option trading tools and calculators and low option commissions. Covered call trading generates a lot of commissions that can cut into your profits.

• Stocks with higher implied volatility will have higher expected returns on covered call trades, but a higher risk of loss on the trade. The implied volatility is a rough estimate of the expected annual return of trading covered calls on that particular stock.

• Covered call trading involves placing five to seven trades per year with the same lump of money and earning a small profit each time. One bad trade where the stock value drops significantly can wipe out a year's worth of profits. Monitor your stock prices, and be ready to close a position early to minimize the losses.

• Stock and options trading can lead to significant loss of capital. Do your own research and understand the risks involved before trading.

References

• Options Industry Council: Covered Calls