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To put this strategy to use, you need to own the stock. Selling naked calls is generally very risky because it provides one with limited returns but unlimited risk.

What are covered calls?

An investor basically writes a call option (sells calls) that is backed by with the equivalent number of shares, hence the name covered call. If the stock is purchased at the same time a call contract is sold it's often referred to as a "buy write". On the other hand, if the shares are already from a previous purchase, it is referred to as "overwrite." This is the most basic and widely used strategy, which combines the flexibility of options with stock ownership.

Let us look at an example

Let's say you own 300 shares in Seadrill (SDRL), which is currently trading at 40, and you think that there is little chance that the stock is going to hit 45 in the next three to six months. You could for example, sell calls with a strike of 45. The premium you receive is yours to keep. If in the next three to six months SDRL does not trade above 45 (usually the stock has to trade above the strike price on the last trading day), then you hold onto the shares as well as the premium.

Benefits of employing this strategy

Income generation

Each contract trades at a premium (the higher the beta the higher the premium), and the buyer of the contract pays you that premium for the right to purchase 100 shares of the stock at the strike price. The premium is deposited immediately into your brokerage account.

Downside protection and reduction in Portfolio volatility

If the stock drops in value, the premium collected at least provides some type of return, and it can offset all or part of the loss depending on how severely the stock has pulled back. For example, if you sold a covered call against a stock when it was trading $20 for a premium of $2.50, then as long as the stock does not drop below $17.50 you are okay. In essence, you have reduced your entry price to $17.50. If this strategy is actively employed, then you could in general significantly reduce the volatility your portfolio is subjected to.

Predetermined rate of Return

This strategy gives you a decent idea of what your rate of return on your investment will be. Regardless of what takes place you still get to keep the premium. If your shares are called away from you at the strike price, it is easy to figure your profit; this is the difference from what you paid for the stock and the strike price you sold the option, plus the premium you collected. So let's take the above example. If SDRL trades above 45, your shares are called, and you are out at 45. Let's assume you paid $40 for each share, your profit is 5 plus the 2.50 which you received in premium for a total gain of 18.75%.

If the stock starts to drop in price, you lose money on paper (much like any other share holder) when the price of the stock falls in excess of the premium you received.

Converts a common stock into a dividend paying stock

The moment you sell the call option, the stock you own, in essence, has turned into a dividend paying-stock; if it already pays a dividend you have turbo charged your gains.

Repeat the process all over again

If your shares have not been called away from you, you can repeat the whole process again. Utilized properly this strategy can produce an income stream that can surpass the dividend paid out by that specific stock. If the stock does not pay out a dividend, you have just converted into one that does. If the stock is called, there is nothing to prevent you from buying another good stock and repeating the whole process again. Alternatively, if you do not want your shares to be called away, you could roll the call. Buy the call you sold back and sell new out of the money calls.

Buy back the call

If you sold the call for a premium of 2.50 and the call is now trading at 1.00, you could buy the call back, and you still get to keep the difference, which in this case amounts to $1.50. You could take things one step further and start the whole process again by selling calls that are fetching higher premiums. For example, you sold calls on stock X when it was trading at 37 with a strike at 40 for a premium of $2.50. The stock is now trading at 34, so you buy the call back and sell new calls with a strike at 37.50.

Covered call Strategy for Wells Fargo & company (WFC):

The stock is rather overbought and has generated a series of negative divergence signals. A negative divergence is when several technical indicators refuse to confirm a stock's recent highs. The stock could easily pullback to the 30.00 ranges. This is a short to midterm strategy (3-6 months). Long term the trend is still up and the outlook remains bullish. A weekly close below 32.00 should result in a test of the 29.80-30.50 ranges. Potentially it could briefly trade down to the 28 ranges before putting in a bottom.

The stock is still in the process of topping out and could test the 34.00-34.50 ranges again. A good sign that a stock is going to pullback is when it puts in a series of lower highs. The Jan 35.00, 2012 calls are trading in the $1.58-1.63 ranges. If the stock trades to the suggested ranges the calls should trade in the 1.80-1.90 ranges. For this example we will assume that we can sell the calls for $1.80. For each call sold, $180 will be deposited into your account.

If the stock trades above 35.00 there is a chance that your shares could be called away. One way to avoid this is to roll the calls. Buy back the old calls and sell new calls. If the stock does not trade above 35.00 you get to keep the premium which in this case works out 5.4% in roughly 6 months. In addition to the premium you will walk away with some capital gains depending which will vary based on your entry price. This strategy should only be employed when a stock is overbought and you are looking to limit your downside or walk away with a predetermined amount of profit.

An additional suggestion

If you are bullish on the long term prospects of this stock, then you could sell puts at with strikes in the 29-30 ranges when the stock trades in the 30.00-31.00 ranges. The Jan 2013, 30 puts are currently trading in the $1.08-$1.11 ranges. If the stock pulls back to the stated ranges these puts should trade in the 2.00-2.25 ranges. If the shares are assigned to your account you will get in at 28.00 or better. If the shares are not assigned to your account, you walk away with an extra 6.8%.

Company: Wells Fargo & Co

Basic Key ratios

  1. Percentage held by institutions = 77%
  2. Short ratio = 1.8%
  3. 52 week change = 48%
  4. Profit margins = 22.5%
  5. Quarterly earnings growth = 5.10%
  6. Quarterly revenue growth = 17%
  7. Beta = 1.16
  8. Relative Strength 52 weeks = 81
  9. 5 year sales growth rate = 13.56%
  10. EPS vs 1 year ago = 17.1%
  11. Sales vs 1 year ago = -6%

Growth

  1. Net Income ($mil) 12/2011 = 16211
  2. Net Income ($mil) 12/2010 = 12663
  3. Net Income ($mil) 12/2009 = 12667
  4. EBITDA ($mil) 12/2011 = 30238
  5. EBITDA ($mil) 12/2010 = 26132
  6. EBITDA ($mil) 12/2009 = 27015
  7. Cash Flow ($/share) 12/2011 = 3.43
  8. Cash Flow ($/share) 12/2010 = 2.77
  9. Cash Flow ($/share) 12/2009 = 3.01
  10. Sales ($mil) 12/2011 = 87597
  11. Sales ($mil) 12/2010 = 93249
  12. Sales ($mil) 12/2009 = 98636
  13. Annual EPS before NRI 12/2007 = 2.38
  14. Annual EPS before NRI 12/2008 = 0.75
  15. Annual EPS before NRI 12/2009 = 1.81
  16. Annual EPS before NRI 12/2010 = 2.26
  17. Annual EPS before NRI 12/2011 = 2.82

Dividend history

  1. Dividend Yield = 2.6
  2. Dividend Yield 5 Year Average = 2.4
  3. Dividend 5 year Growth = - 7.31%

Dividend sustainability

  1. Payout Ratio = 0.20
  2. Payout Ratio 5 Year Average = 0.41

Performance

  1. Next 3-5 Year Estimate EPS Growth rate = 10.09
  2. 5 Year History EPS Growth = 5.96
  3. ROE 5 Year Average = 12.58
  4. Return on Investment = 5.98
  5. Current Ratio = 0.9
  6. Current Ratio 5 Year Average = 0.97
  7. Quick Ratio = 0.85
  8. Cash Ratio = 0.14
  9. Interest Coverage = 5.00
  10. Retention rate = 80%

Conclusion

Only put this strategy to play if you can deal with the possibility of having your shares called. One way to deal with this, if you are sitting on substantial gains and do not to deal with the extra tax issues, is to roll the calls. Buy back the old calls and sell new slightly out of the money calls.

EPS and Price Vs industry charts obtained from zacks.com. A major portion of the historical/research data used in this article was obtained from zacks.com. Options tables sourced from yahoofinance.com.. Earnings and growth rates sourced from dailyfinance.com

Disclaimer

It is imperative that you do your due diligence and then determine if the above strategy meets with your risk tolerance levels. The Latin maxim caveat emptor applies-let the buyer beware

Source: Wells Fargo: Hedge Your Position With The Chance To Earn An Extra 5.4%