How to Trade Covered Calls
Covered-call trading is an option trading strategy that involves buying shares of stock and then selling call options against those shares. The profit comes from the premiums earned by selling the call options. The trade is "covered" by the shares owned if the buyer of the options elects to exercise the contracts. In the right stock market conditions, covered-call trading can provide an attractive annual return.
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Instructions
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Open an account with an online discount stockbroker authorized for option trading. You must document your investing experience to trade options in a brokerage account. Covered-call trading requires Level 1 authorization,which requires the least amount of investment experience. Beginners will be granted Level 1 trading authorization.
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Establish a stock-screening profile using your brokerage account option screening tools. Criteria for covered-call trading can be a range of stock prices, implied volatility and option volume. For example, you may want to screen stocks in a price range of $20 to $25, implied volatility of 20 to 30 percent and option volume of at least 200 contracts per day.
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Select stocks from your screen list to be your covered-call candidates. The stocks should have a price trend of level to slightly rising. There should be options available with a strike price just above the current share price and there should be no pending news that will significantly affect the stock price.
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Select the call option to sell. Look up the current price of the selected stock and select "Option Chain" to be taken to the option-pricing screen. Select the call option with the next strike price above the current share price and an expiration date two to three months in the future.
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Pull the selected call option to the option-trading screen of your online brokerage account. From the option chain, you can select the call option, and your brokerage account will display a menu on which you indicate you want to place a covered-call trade. When you select covered calls, the call-option trading screen with display the stock symbol, options symbol and current price.
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Place the covered-call trade by entering the number of shares to buy, number of call-option contracts to sell and net price of the trade. For example, your selected stock is trading for $24.50 per share and the price of the call option is $1.00. You could enter 200 shares to buy, two call options to sell at a net debit of $23.50. The total cost to enter this trade will be $4,700 -- $23.50 times 200 -- plus commissions.
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Repeat the covered-call trade after the call options expire. If the stock price is above the strike price of the option, the stock will be called and you will repeat the entire trade process. If the stock price is below the strike price of the option, the options will expire worthless and you can sell more contracts against the same stock. In the example above, the call option had a strike price of $25. If the stock is above $25 at expiration, you would get $5,000 when the stock is called away at $25, a $300 profit, less commissions. If the stock was below $25, you keep the $200 received for selling the call options and can sell more with a future expiration date.
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Tips & Warnings
Smart Money magazine provides an annual review of online stockbrokers. For 2010, Fidelity and E-Trade were rated as the top brokers. You must buy 100 shares of stock for each call option you wish to sell. Select stocks with share prices that fit your investment criteria. If you want to trade in $5,000 increments and sell two call options with each trade, you want stocks that cost less than $25 per share.
Stock options expire on the Saturday following the third Friday of the expiration month. You can renew your covered-call trade on the following Monday.
Set up a practice trading account with your broker or at the Chicago Board Options Exchange -- CBOE -- website.
Covered-call trading works best in a level to rising market. This strategy provides little downside protection and a sharp price drop in a stock can wipe out the profits of several successful covered-call trades.
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