How to Write Covered Call Stock Options
Covered call writing is a popular stock and option strategy to earn an attractive income level. Covered call writing involves buying stock and selling call options against the stock position. Covered calls are considered to be a conservative option trading strategy. The key to profitable covered call writing is selecting good stocks.
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Instructions
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Open and fund a brokerage account with a broker that specializes in helping option traders. The Barron's 2010 Broker Review gives high marks to Thinkorswim, TradeMonster, MB Trading and OptionsXpress for trading options.
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Set criteria for an option search that will provide profitable covered call trades. Criteria should include a stock price range, call option implied volatility and option trading activity. Covered calls trade in 100 share lots, so pick a share price range to fit your trade size goal.
Implied volatility will give an indication of the risk and expected annual return from the strategy. Implied volatility above 20 to 25 percent is probably too risky for covered call trading. The stock should have call option volume in near the money strike prices of several hundred contracts per day.
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Use your online broker's option screening tools and your selection criteria to screen for possible covered call stock candidates. Stocks from the screen should be reviewed for covered call suitability. The best stocks have share prices that increase in value at a moderate rate.
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Pick a stock and corresponding call options for covered call trades. Option prices are found by selecting option chain next to the stock quote price. The stock will be a candidate from the screening process. The call option should be the next strike price higher and an expiration date two to three months in the future. For example, Direct TV, stock symbol DTV, is selling for $34.35 per share and the $36 strike price option that expires in two months is quoted at $1.25.
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Enter the covered call trade using the broker's covered call trading screen. Covered call trades are entered with the stock symbol and number of shares and option symbol and number of contracts. The trade price is a net debit price. To trade one DTV covered call shares would be 100 and contracts would be 1. The net price of $34.35 minus $1.25, or $33.10, would be entered and the trade executed. The cost to open the trade would be $3,310 plus commissions.
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Tips & Warnings
A quick way to go from the option chain to the covered call order screen is to select the call option and then select covered call from the menu on the option quote page. This will take you to the trading screen with the symbols and prices already populated.
Many brokers will offer a free practice trading account where you can trade with simulated money. Use the practice account to learn the broker's trading system and practice your strategy before trading with real money.
The maximum profit for a covered call trade occurs when the stock share price moves above the option strike price and the option is exercised to call the stock away. You will receive the strike price for your shares. In the example, if the call options is exercised, the trade would return $36 per share or an 8.8 percent return for two months.
Always include commission costs in your profit calculations. A covered call trade incurs a commission for the stock purchase and a commission for the call sale.
The worst outcome for covered call trading is if the stock price falls below the net cost of the trade. Covered call trading is designed to make small profits five to six times a year on the money invested. One big loss can wipe out the profits of several covered call trades. Be ready to close a trade quickly if it moves to a loss position.
References
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