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Option Trading Tips - Writing Covered Calls
Writing Covered Calls is a conservative strategy where you buy a stock that you would like to invest in and then write a call option against that stock.
This is a cashflow generating strategy that not only offers downside protection that you otherwise wouldnt enjoy if you just bought the stock, but also gives you the ability to generate a consistent monthly income, for only minutes of your time.
The person who buys your call option now has the right to purchase your shares at the strike price (agreed sale price) anytime before the option expires.
Lets say that you own 1000 shares in Microsoft for example and that you sell a call option which gives the buyer of that option the right but not the obligation to buy your 1000 shares at $30 within the next 30 days.
If Microsoft finishes the month below $30 you get to keep both your shares and the option premium, which lets say in this case is $0.90 per share or $900.
However if Microsoft finishes the month above $30, then you will be assigned, which means you now have to sell your stock to the option buyer for $30.
If the strike price of the call option is higher than what you originally paid for the stock, then you will in fact be forced to sell at a profit.
In sideways and moderately rising markets, writing covered calls in this way can be an excellent strategy for generating a consistent monthly cashflow.
Further to this, as a large percentage of options expire worthless, you can often write covered calls for many months on a stock before you are assigned and forced to sell it.
However as with all option trading strategies, there are pitfalls that you will need to avoid if you are to be consistently profitable.
Here are a few tips that may help you write covered calls successfully.
- Never write covered calls on a stock that you are not prepared to sell.
Disposing of an asset such as stocks (particularly if you realize a large capital gain) will have taxation consequences that may or may not be favorable to your current financial situation.
Always seek advice your accountant and/or financial advisor before implementing any investment strategy.
- Make sure you check the fundamentals of the underlying stock to make sure that you would be happy to own it even if options/writing covered calls didnt exist.
A great resource for checking the fundamental ratings for stocks is at http://www.morningstar.com
- Never enter a Covered Call trade just because the option premium looks attractive. Higher option premiums (10-15% or more) often mean that the stock is more volatile i.e. prone to huge price swings and therefore greater risk.
I personally target the larger, more liquid and stable companies with monthly call option premiums between the 3-6% range.
One of my personal favorites and a stock that I have had considerable success writing covered calls on over the years is Oracle (ORCL).
Ive also had consistent success with Intel (INTC) and Nokia (NOK). At times the Nasdaq Tracking Unit (QQQQ) is also attractive (a 3% yield is the highest Ive ever seen it though).
- Dont hold stocks at least 2 days either side of earnings announcements. Much of the time expectations of good and even great earnings are already priced into the stock and should the stock fall short of expectations or even worse disappoint, a virtual bloodbath can follow. Ive experienced declines of 30-50% in just a few days by holding my covered call stocks over earnings announcements.
Taking in 3-6% in Call option premium does little to protect against such steep, rapid declines.
Dont get me wrong, it can also be good time to be a stockholder at these times if the earnings numbers are really great, but Im a little more conservative and to me its just not worth the risk. You can always buy back in afterwards anyway!
- Always take a look at stock charts when choosing a stock to write covered calls on. There are 2 basic patterns that I look for:
1) A moderate uptrend.
2) A sideways trend.
However the most conservative / safe chart pattern for covered call writing (in my experience) appears after a stock has had a steep sell off and has begun to move sideways for a couple of months.
This is a type of bottoming pattern where much of the downside risk has already been sold out of the stock.
As covered call writers its always important to remember that our risk lies if the stock falls sharply, so we want to do our best to reduce this risk as best we can. This is just one way that I have found to be effective.
If you go to http://www.stockcharts.com and pull up the chart for the QQQQ during the early part of 2003, youll see this exact bottoming pattern. I successfully wrote covered calls on the QQQQ for about 4 months during this time before I allowed myself to be assigned and moved onto another opportunity.
There you have it. Hopefully these tips will help you on your way to making consistent profits and monthly cashflow writing covered calls.
Oh, it also goes without saying but Ill say it anyway, "Dont put all your eggs in one basket!"
Always spread your investment capital across different stocks in different sectors.
For more information on how to write covered calls go to: http://www.callwriter.com
Happy option trading and investing!
About The Author
James Thomas is a successful private option trader and has created http://www.option-trading tips.com as an informative, no-nonsense resource full of useful tips and information designed to help option traders and investors to become more profitable.