Call options give the option buyer the right to buy stock (from the option seller) at the strike price. Put options give the option buyer the right to sell stock (to the option seller). Call options are covered calls when the option seller owns the stock the covered calls are written against.

Stock options are traded each business day in units of 100 shares; fractions of a unit can't be traded. Writing covered calls gives someone the right to buy stock you own, at the option strike price. You can also buy stock with the intent of writing covered calls as soon as your buy is confirmed. This strategy is known as buy-write.

Even though you have sold covered calls, you still own the stock until it's called. If it pays a dividend you benefit. If it takes a dive, you could lose money. Make sure to research the stock underlying the covered calls thoroughly.

When writing covered calls, the option premium from the sale is deposited into your account the next business day. It is yours regardless of what the stocks or covered calls do in the future.

By writing covered calls, you are selling the upside potential of stock to speculators. Since your focus is on monthly income not long-term capital gain when writing covered calls, it is advantageous if the stock price goes up and the stock gets called away.

When writing covered calls you must do one of the following:

1. Allow your stock to be sold at the option strike price anytime before the covered calls expire.
2. Buy the covered calls back on the open market before they are exercised.
3. Let the covered calls expire unexercised (on the third Friday of the month).

For instance, if you purchase 100 shares of stock for $4.75 per share, you could write $5.00 covered calls. Let's say the option premium is $0.50. The premium yield would be $0.50 divided by $4.75, which is 10½% in 36 days or less, on the covered call option premium alone. If you sell covered calls and the stock does close above $5.00 on the option expiration date, your stock will be called for $5.00. This would produce a capital gain of $0.25 on the sale of your stock in addition to the $0.50 per share covered call option premium already received.

Otherwise, if the stock does not close above $5.00 on the option expiration date, the stock will probably not be called. You could then write covered calls again for the next month using the same stock to cover the covered calls.

To Write Covered Calls

1. Have your broker buy the stock you've selected for covered calls in increments of 100 shares.
2. Then, have him sell the covered calls.  If you don't want the stock to be called, you could roll up or roll forward. You could keep writing covered calls and collecting option premiums each month until called.

Covered Call Strategy

Writing covered calls works well in bull markets and flat markets. Writing covered calls can even cushion losses during a bear market. Analytical tools are used to select covered call options that will provide at least a 10% return over a relatively short period of time, usually less than 2 months. Most covered call research provided to the subscribers is for stocks that are priced under $30.00 per share. This is important because stocks must be bought in blocks of 100 shares in order to write a call contract.

The criteria for selecting covered call options can be summarised as follows:
Stock costs less than $30.00 per share
Out of the money call premium is greater than 10% of the stock price
Call option has sufficient volume and open interest
Call option to expire in less than 2 months
Stock has positive daily price momentum

Generate Income Writing Covered Calls

Writing covered calls is becoming increasingly popular with active individual investors. When used properly, covered call writing can be an effective strategy for income and growth. The basic covered call strategy is to generate income by selling call options on stocks that you already own. The strategy focuses on buying stocks whose near-term call options exhibit high premiums, usually greater than 10% of the stock price. The procedure is to first buy the stock and then immediately sell the "covered" call option. By writing near-term, slightly out-of-the-money calls against a stock that you already own, two outcomes are possible when the options expire:

1. The stock price is at or above the option strike price: In this case, the options will ordinarily be "exercised" by the buyer (i.e. your stock is "called away" from you by the holder of those options at the strike price of the options). Your profit on the transaction includes the premium that you received for writing the options, plus the difference between the strike price of the option and your purchase price of the stock. You give up any further participation in the upside of the stock price above the strike price of the option
2. The stock price is below the option strike price: At expiration, "out-of-the-money" call options will ordinarily expire worthless to the option owner, who is unlikely to "call" the stock away from you for a higher price than it would cost on the open market. Therefore, in addition to still owning the underlying shares of stock, you pocket the premium that you received for selling the call options. If the stock price has fallen since purchase, your loss has been cushioned by the income from the option. Furthermore, you now have the opportunity to earn still more from the stock by writing covered calls AGAIN and AGAIN, until you either sell the stock or it gets "called away" from you by an option holder.

How Do I Identify a Good Covered Call Candidate?

A question that is often asked is, "how do identify a CC candidate"? There are many fundamentals that must be considered to make sure that your risk versus reward criteria is met.

There are various theories and strategies available for deciding which underlying stock and its associated CC are right for your investment criteria. We would like to outline just a few things that we consider important when making your CC decisions. Here is a list that may assist you when reviewing a particular stock before making an investment in that stock and writing the CC:

• First, take a look at the Bollinger Bands/Relative Strength Index (BB/RSI). Is the stock trending up or down? Is the stock at the lower range of the RSI and down toward the bottom BB band? Once you find a CC candidate that has a stock price toward the bottom BB band and has a relatively low RSI with an upward trend, take a look at the fundamentals of the stock.
• Take a look at the profile of the company. What industry and business sector is the company involved in? Is this the type of sector you think has growth potential in the near term? How were earnings for the previous quarter? Take a look at the company summary and see if the numbers meet your criteria.
• Two areas are the profitability and management effectiveness of the company. This number should be positive. If not, you should do more research and find out when they expect to be profitable.
• 52 week high/low - Is the stock price at the 52 week high or low? Is the stock trending down and could set a new low (this shouldn't be the case if you reviewed the BB/RSI and selected a stock that is currently trending up). What is causing the stock to be at a high or low; good quarterly earnings, rumors, etc.
• Price/Earning Ratio (PE) - Does the stock have a PE ratio that is in line with companies in the same industry sector? If not, do a little homework to find out why it has a high or low valuation versus the rest of the industry.
• Message Boards - This can be great information or it can steer you in a negative direction. Be careful what you read into message threads, you don't always know the motives of the people posting to a particular thread. There is as much good information as there is misinformation. Rely on the fundamentals and make your own decisions based on your risk versus reward criteria. Nobody knows better than you what you are willing to risk for a pre-determined gain.
• Volatility - How Does it Affect Option Premiums?
• High option premiums are usually generated by volatility in the stock price. If there is some sort of positive or negative news or other excitement about the company the stock price will be affected, sending the premium up or down. Why are there call options with such high premiums? We will quote from the expert to answer this question:"More volatile underlying stocks have higher option prices. This relationship is logical, because if a stock has the ability to move a relatively large distance upward, buyers of the calls are willing to pay higher prices for the calls--and sellers demand them as well." McMillan in "Options As A Strategic Investment"

By having your research pool include stocks that produce high CC premiums you have another angle to find stocks that can possibly help you make monthly and yearly returns that are relatively conservative (compared to strictly buying call options) yet potentially more profitable than simply buying and holding stock.  You must still do your own detailed research of the fundamentals of the underlying stock to see if it's a stock you'd be comfortable holding if the stock price drops.

How Do I Write a Covered Call?

To write a CC, you must first own the optionable stock. The CC writer can buy stock in 100 share blocks and simultaneously sell an equivalent number of call options against the underlying stock (what is known as a "buy/write"). One option contract is equivalent to 100 shares of stock. So, if you own 500 shares of a particular stock, you will sell 5 call option contracts.

The writer sells call options against stock that is already owned. This strategy is often referred to as "legging in".

Here are some simple steps to write a covered call:

Identify and fully research an optionable stock that has a CC premium that meets your risk versus reward criteria. Instruct your stock broker or enter your order through an on-line brokerage account and purchase the stock. You can then enter a call option order to sell a specific number of option contracts against your purchased shares. For example, you could purchase 500 shares and then turn around and sell 5 call option contracts against those shares. 

You must specify the month and strike price for the call option contract. Options are available in specific months and at specific strike prices. Here is an example of available strike prices - $5.00, $7.50, $10.00, $12.50, $15.00, $17.50, $20.00, $22.50, $25.00, $30.00 and $5 increments thereafter for stocks over $25.

Option Expiration Day - Expiration day is the third Friday of each month. When you write the CC (sell call options) you have sold a call that expires on the third Friday of a particular month. On this date, your call options will either be called out or exercised (the stock price is above the call option strike price) or the option will expire worthless (the stock price is below the call option strike price).

If your option is called out (exercised) your stock will be sold at the CC strike price. You will keep the CC premium as well as the difference between your stock purchase price and the call option strike price.

If the call option expires with the stock price below the option price, you still own your stock and you keep the CC premium. You can then turn around and write another CC on the same underlying stock.

Commissions - Check with your broker about commissions charged when purchasing stock as well as writing covered calls. You will be charged commissions for purchasing stock, selling the CC and selling your stock if the call option you have sold is called out (exercised).

Margin - Most brokerage firm accounts allow margin. That means that you can purchase stocks wherein you put up 50% and the brokerage puts up 50%. For the cost of interest charged on your margin account you have twice the amount of purchasing power. If you purchase stock on margin, then sell a CC your percent return is doubled, minus the margin loan interest charge.

When to write covered calls

One thing that should be emphasised is the fact that covered call writers simply cannot ignore the prevailing market trend. If the market is trending down, this fact is more important than the stock's individual direction. That is, a stock will usually counter-trend the overall market for only so long and will correct. And the correction frequently is major. Conversely, it is always a mistake to write covered calls on a stock that is dropping in a rising market and showing greater weakness than the market.


One question we always get is how on earth we can advise anyone to write covered calls in a down-trending market. Don't we know you can't do that? Well, we don't. First of all, a downtrend can be anything from a very gentle one to nearly vertical. Second, there are trading-range periods in every down-trending market, during which covered calls are easy to write. Third, the best companies don't lose value like the flaky ones. Priceline may have gone from $70 to $2 in the bull market crash, but WalMart didn't.

Actually, it can be easier to write in a down-trending market than in a channeling (ranging) market. The reason is that a channeling stock will not always turn at the same point. If they always hit the same support and resistance points in the range, writing them would be child's play. But they can pull back well before the last resistance point is reached.

Takeover Candidates

Stocks in the takeover rumor mill typically see their options' premiums, especially the front- or near-term expiration, get pumped up. Skews basically involves creating a calendar spread or the sale of the more expensive short-term option against the simultaneous purchase of the relatively less expensive longer-term option. But a covered call can accomplish a similar feat without the risk that an all-cash or sooner-than-expected takeover bid brings to owning longer-dated options.

Ways to Profit with Covered Calls

For anyone not familiar with covered calls, they are simple: you buy shares of stock and simultaneously sell call options ("calls") on them, and the price you get for selling the calls (the "premium") goes into your pocket as income. If the calls you sold are exercised, you are obligated to sell the stock at the calls' exercise price, which is known as being "called out" of the stock, or as being "assigned." Because you own the stock underlying the calls, the calls are "covered" and you have them available for delivery to the buyer if the calls are exercised - if you didn't own the stock, the calls would be naked. If you are not called out of the stock when the calls expire, you either sell the stock or sell more call options on the stock the next month for more premium income.

1. Write covered calls on stocks that offer a high combination of return and stability. This is the basic strategy, and it has worked since standardized options came into existence in the 1970s. Every month you buy one or more stocks, write calls on them for income and then sell the stock, either when you are called out or at expiration. Or if the stock is still carrying high premium consider selling more calls the following month. Generally, the best return is made from writing the at-the-money (ATM) calls, which is the call that is the same or almost the same as the stock's price.
2. Write covered calls on stocks that already are in your portfolio. You don't have to buy them; you already own them. It is one of the oldest trading axioms that you should only write covered calls on stocks you want (or are willing) to own, since if you are not called out, you will own them. Well, you already own these. Writing covered calls on them makes these stocks produce income for you, like collecting a monthly dividend. This strategy does not produce as much return as the first strategy, but it does produce a return. Another way to look at it is that selling calls on portfolio stocks keeps lowering your basis in them. Comment: We've seen so many calls written on a portfolio stock that the trader owned the stock for free. To collect 40% of the stock basis in call premium is not uncommon. If you don't want to be called out of the stock for any reason, write out-of-the-money calls. But if you are called out, so what? You can always buy it again.
3. Tactical Unwind. Stock and option prices will change while you're in the trade. If there is more money in letting the position ride or unwinding it, you unwind a position simply by repurchasing the calls sold and then selling the stock. After a trade is unwound, your capital is safely back in your account, ready for another trade!
4. Tactical Roll. Roll the calls into a higher strike price when the stock moves up if there is more profit there. If the stock moves up while you're in the trade, it sometimes is advantageous to buy back the calls you sold and sell calls with a higher strike price. This is known as rolling up. Sometimes there is more money to be made from rolling up than the original trade presented. Keep in mind that the roll up only yields a bigger return if the stock stays at the new price level or advances further, so do your technical analysis before the roll. Sometimes it is necessary to roll down, also. This happens when the stock price drops and the stock is showing technical weakness. When the stock has dropped, the calls will be much cheaper to buy back. By rolling down (buying back the calls sold and selling lower-strike calls), you can get more protection by selling an in-the-money call. Rolling down is not a profit strategy but one to protect your investment or minimize a potential loss.
5. The Time Decay Strategy. Buy back the calls in the last two weeks before expiration when they have lost most of their value. One of the knocks on options is that - unlike stocks - they are not tangible assets and expire, plus they lose value over time. The loss of value over time is known as time decay. Most of the time decay happens in the last 30 days of an option's life, and the most of that in the last few days. If you are a call buyer, time is not on your side, because the asset loses a little value every day and eventually will expire. But time is the call writer's friend. Many experienced call writers will sell a call with 4 - 6 weeks remaining until expiration, then buy it back in the last 10 days at a fraction of the price paid and sell the stock. Why bother unwinding to profit from time decay instead of letting the calls go to expiration? The reason is that you can put your trading capital back to work in another trade before expiration. But also remember that getting out of the trade terminates your risk, also.

Example: You buy a stock for $20.00 and write the $20 call on it for a $1.15 premium. Then with 9 days left before expiration, the stock is $20.25 and the call can be repurchased for $0.40. Buying back the call still leaves you with a $0.75 profit from writing the calls (1.15 - .40), and you get an additional $0.25 when you sell the stock at the current market price.

Comment: This strategy works best on out-of-the-money calls, which lose the most time value. It also works well on at-the-money calls. However, in-the-money calls do not lose very much value as time progresses, to the time decay strategy does not work for them. Also, this is not a good strategy for volatile stocks, which move too much; it works best on stable stocks.

The time decay strategy is a variant of the Tactical Unwind, but with a difference. The Tactical Unwind is done to pull more profit out of a trade because the stock's price has advanced and the current option prices make the profit possible. The time decay unwind is done in the last week or so before option expiration, and the profit comes from the option's loss of value.

There are other great strategies for naked calls and puts and for option spreads, but those will have to wait for another newsletter.

Covered Call Success Tips

How to increase your yield on covered call options.

• Avoid biotech stocks (drugs, medical devices), they are very volatile and are not good covered call candidates.
• Instead of selling stocks outright, consider writing a covered call. That way you name your sales price and pick up an option premium on the covered call sale.
• Sort the covered call guide by dividend yield if you are interested in covered call options that pay dividends.
• You should write a near-month covered call. This results in higher daily yields than if you write a covered call with expirations two or more months out.
• Writing a covered call on stocks priced at less than $30 per share creates higher percentage covered call option premium yield than writing a covered call on higher-priced stocks.
• When writing covered call options, use a limit order to buy the stock. You can specify a GTC limit order and wait for the order to be filled. Then use a a market order to sell the covered call quickly.
• The use of a margin loan to buy the stock increases the premium yield on a covered call! Writing a covered call on margin is a higher risk strategy, which combines leverage with high returns.
• Do your own research, make your own picks. There are hundreds of web-sites that recommend stocks and covered calls, but they don't always have your best interest at heart.
• One of the biggest mistakes made by writers of covered call options is focusing on the return of the covered call and not on the underlying stock. Don't base your decision solely on the largest covered call yield.
• Option premium quotes can become stale because the covered call option has not been traded recently
• After selling a covered call, continue to watch the price of both the stock and option
• If a stock which you bought to sell a covered call against is declining in value, consider selling the stock outright.  You must first close each open covered call by buying the call back.
• Covered call option premiums change rapidly; a covered call with a high premium yield yesterday may not have the same premium yield today.
• Premium on a covered call tends to decline as its expiration date approaches.

Equal but Not the Same

To qualify as a valid covered call, both the stock and the option must be in the same account, the long stock must be the same underlying security specified by the short option, and you must hold at least enough shares of stock to fulfill the delivery requirement of the call option. These criteria are important because they determine in what type of account the position can be established, as well as the margin and maintenance requirements. I've mentioned these requirements because some people will point out that selling a put option short (i.e., "naked" or uncovered) offers a similar profit/loss profile as a covered call but requires less capital and can be established through a single transaction. But it's important to note that many brokerage firms may not allow individuals to sell naked options because they're more highly leveraged and therefore, in percentage terms, a riskier position.