Contrary to what many people may think, investing in covered calls is one of the safest investments available in the markets. While these positions are somewhat advanced, they are approved for many pension funds and mutual funds. Naturally, some due diligence is required as the right type of companies need to be selected for this kind of investment. A call option gives a buyer the right to purchase 100 shares of a particular stock at a specific price known as the strike price of the option. The option has an expiration month where it expires worthless if not been exercised by its holder. If the stock price rises above the strike price, then the option is "in the money" and the option seller is obligated to provide the stock at that strike price. If the seller does not have the stock, then it has to be purchased at market price. A covered call is when the option seller buys the shares as insurance in case the option he sells is exercised against him. As a general rule, the value of options decay faster when getting closer to expiration, and also as their strike prices get further away from the actual price of the stock.
Things You'll Need
- Yahoo! Finance - Stock Screener
Finding the Best Stocks for Covered Calls
Select stocks with a market capitalization of $500 million or more. Go to Yahoo! Stock Screener and enter "500 mil" as a minimum value. Larger cap stocks are desired as they tend to be far less volatile than smaller stocks.
Select stocks belonging to the stock indexes. This will ensure they have sufficient liquidity and are traded by large institutions which give them stability. On the Index Membership selection in Yahoo! Stock Screener, select either Dow Jones Industrials or S&P 500.
Select stocks market analysts feel are healthy and poised for growth. Under the Average Analyst Recommendation option on the Stock Screener, select "Buy/Hold (2) rating or better."
Select stocks are estimated to grow over the next five years. Under the "Est. 5 Yr EPS Growth" option on the Stock Screener, select "Up more than 25%."
Select stocks with relatively low price to earnings ratios indicating they have room to grow. On the Stock Screener, select a maximum Price/Earnings ratio of 30.
Before running the screener, it is a good idea to consider what share price on which you should focus. If your capital is limited, then select a stock price of $25 or less on the Stock Screener.
After this is done, click the Find Stocks button at the bottom of the screen.
For each screened stock, examine the one year price chart by using the hyperlink labeled "chart" located to the right side of the screen. Determine the current trend of each stock and discard those that are in a downward trend.
From the list of stocks that are left from steps one through seven, purchase shares of stock in blocks of 100 shares each.
For each 100 shares of stock bought, sell one call option from the nearest month which is at least one strike price out of the money. This cash will immediately be placed in your account.
Tips & Warnings
- The best time to set up a cover call position is on a day when the major indexes are having a down day. However, if you already own the stock ahead of time, then you should select a day when the indexes are trading up.
- Your objective is for the call options that you sold to expire worthless. This way, you get to keep all the money received and are free to sell more options against your stocks and do it all over again.
- You should never sell the stocks until the options are liquidated. An uncovered option exposes you to unlimited risk.
- "Covered Calls and LEAPS: A Wealth Option"; Joseph Hooper and Aaron Zalewski; 2007
- Photo Credit Comstock Images/Comstock/Getty Images
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