Digging Beneath the Surface of This Popular Income Strategy

Many traders are familiar with a “covered call” option strategy…

You can write (sell to open) call options on a stock you own to generate extra income.

If it’s a stock that is already paying a healthy dividend, you can really boost your returns.

Yet sometimes traders aren’t always sure when to use a covered call strategy.

So today, I want to look at some of the factors to consider before putting this strategy into action.

A Neutral Strategy

With options, you always need to understand your obligations – and this strategy is no exception.

By writing a call option, you’re required to hand over your shares at the option’s strike price if your call option is exercised.

So you should only write your option at a price that you’re willing to sell your shares.

But what might seem like a good price today could change quickly if the stock rallies. That’s why you only use a covered call if you are neutral on a stock.

Put simply, if you’re bullish on the stock, then leave this strategy alone.

It’s a similar story if you are bearish… While collecting call option premium might cushion some of your losses, it’s not going to cover all of those losses if a stock falls heavily.

In that situation, you’d sell your shares directly or protect them by buying a put option. In either case, consider any tax implications and decide what best suits your financial needs and goals.

Ideally, the best time to sell a covered call is when a stock is trading in a sideways range, such as the Boeing (BA) chart below. (Please note that this example is not a recommendation.)

Boeing (BA)

Source: eSignal

After bottoming out last October, BA rallied strongly at the start of this year.

As you can see, from there, it transitioned into a sideways trend.

In this example, you believe that BA is going to remain trading in this range. So you might write your option at around $225 (red line).

There’s a key thing to remember here…

The closer you write your call option to the current stock price, the more premium you will receive.

But this also increases the likelihood that your option will be exercised.

If you wrote this option in June when the option strike price was close to the stock price, that could have generated around $10 per share (or $1,000 per contract) on an option with around 45 days until expiry.

As long as the underlying stock closes beneath the strike price at expiration, you get to keep this premium and your shares. That’s the ideal scenario.

Do this repeatedly over six months or longer, and those premiums can really start to add up.

As I mentioned, though, you always need to understand your obligations…

Other Considerations

In this case, if your written call option is exercised, you must hand over your shares at the option’s strike price – no matter how high the underlying shares are trading.

The other thing you need to consider is volatility…

You want to sell when volatility is high. This inflates the value of the options and puts more money into your account.

Then as volatility dies down, it reduces the value of the call option. (Don’t forget that because you’ve sold the call option, you want to see its price fall.)

And time decay is one other factor to consider.

Remember, time decay lessens the value of your options contract. The closer your option gets to expiration, the quicker the value degrades because there’s less time to realize a profit.

Here, it works in the option writer’s favor, and it can help swing the covered call strategy your way.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict

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