Writing covered calls is a stock market strategy that tends to be most effective in a neutral, or sideways moving, securities market. Despite the reputation that most option trading strategies have received in the press, selling covered calls can actually be considered a conservative investment strategy.
Investors write covered calls to supplement their investment income. By selling a call the investor is selling the right, but not the obligation, for another investor to buy the underlying stock at a certain price if exercised on or before a certain date.
As compensation for doing so the seller receives a premium; which is determined by additional factors such as the amount of time left until the option expires, whether or not the option is in-the-money, and overall market expectation for the price of the underlying stock.
In order to execute this strategy (also known as the buy write strategy) there are a few steps that you need to complete.
Identify Potential Stock Purchases
The first thing that you need to do is identify the stock for which you want to sell a call against. This can sometimes be the most difficult part of the entire transaction. Most newer investors simply do not truly understand that having success with writing covered calls essentially depends on the predictability of the underlying stock. Properly screening your investments is crucial to your ability to make money via this options strategy.
You also need to remember that when you are dealing with option contracts, one contract involves one hundred shares of the underlying stock. If you want to sell covered calls on a stock that has a market price of $40 you will need to spend at least $4,000 [$40 x 100 shares] just to be able to sell one call contract.
Purchase the Stock
Once you have selected the stock on which you are planning to sell the call against you will need to purchase sufficient shares. If you want to sell two contracts you need to buy at least 200 shares. If you already own 100 shares of stock for your identified company you can sell an option on those. The key thing to remember when you are selling covered calls is that you must own a sufficient number of shares of the underlying stock to covered the call(s) you sell. If not, you are selling ‘naked’ which is an entirely different, and more speculative, options technique.
Pick Your Strike Price and Expiration Date
Once you own the necessary shares of stock you need to determine at what price and expiration date you wish to sell. Most of the larger, blue chip stocks have options contracts that are available every month while smaller stocks may have quarterly or bi-annual expiration dates. Most beginning investors might be best served by selling near month expiration dates to start. As an investor progresses in his or her abilities they may eventually want to experiment with longer term option contract or even LEAPs.
Execute the Sale
Once you have completed the steps as outlined above you are now ready to execute the transaction. The mechanics of actually selling the call is much the same as a normal buy or sell transaction. Many option platforms, such as thinkorswim, will actually allow you to buy the underlying stock and sell the call almost instantaneously for one low commission.
Like all investments writing covered calls involves risks. Explore the various paper trading options that are currently available online and always practice before attempting this technique with real money. Always set stop losses on your stock at 10% below your purchase price. If the underlying stock drops dramatically you can begin to lose money rather quickly.