Anyone who takes a look at options quickly discovers the most popular strategy: covered call writing. But is the strategy properly classified with all other options as "high risk" or, in fact, is it an amazingly conservative method for earning double-digit returns?
Assuming the basic rules are followed for writing covered calls, it is difficult to fault the strategy; in fact, writers do earn exceptionally high returns and all they give up is the occasional lost opportunity. In those rare cases when stock prices take off, covered call writers get assigned below market value. However, it the majority of instances, those double digit returns do occur. The basic rules to remember are:
1. Always sell calls at strikes above your basis in stock, without exception. You need to make sure you are going to get capital gain, not a capital loss. Covered calls are not appropriate for trying to get back the paper loss on stock that falls below your cost.
2. Pick strikes out of the money, but as close as possible to current value. You get the best outcome when the covered calls strike is only two or three points above current price of the stock; that ensures an attractive premium.
3. Close the position when it becomes profitable. Letting a covered call ride until expiration keeps you exposed to exercise risk. If you sell a call for 6 and its value falls to 3, enter a buy to close order and take your profit; then look for a new call to write.
4. Pick contracts expiring in one to two months. The shorter-term options yield lower dollar value in premium, but higher annualized return. This is because time decay accelerates in the last month, so you are likely to get the best profits with only a few weeks until expiration.
5. Compare returns on an annualized basis. To make valid comparisons, annualize the likely covered call returns. You will realize right away that shorter-term options yield much better than longer-term options. To annualize, divide the option premium by the current price per share; divide the resulting yield by the option holding period; and multiply by 12. For example, a two-month option can be sold for 4 ($400). Current price of the stock is $72. Annualized return is: ( $4 ÷ $72 ) ÷ 3 x 12 = 22.2%
6. Pick high-dividend yielding stocks for covered call writing. Finally, in comparing two or more stocks for covered call writing, if all else is equal, pick the one yielding the highest dividend. And choose the option to reinvest dividends, creating compound returns on the yield. Too many covered call writers overlook the importance of dividends in the overall analysis of covered calls.
Following all of these rules consistently leads to double-digit returns. Even so, covered call writing is a conservative strategy when compared to the simply ownership of shares. For many, the small risk of occasionally having shares called away is worth the high returns. If you have avoided covered call writing, it might be worth a second look.
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