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The Seven Guidelines For Covered Call Writing

The big appeal of covered calls has always been the double-digit annualized return that is not only possible but likely. Gains come from three sources: capital gains on stock sales, dividends, and option premium.

But is it always profitable? No; you can lose money writing covered calls and even experienced options traders can easily overlook this issue. If the stock price rises well above strike, your stock gets called away below market value, so you would have made more profit just owning the stock. However, this does not happen often enough to offset the amazing gains you are going to earn most of the time.

The larger threat is what happens when stock prices fall. The breakeven is your original basis, minus the amount you get for selling the call. For example on March 30, 2012, Exxon Mobil (NYSE:XOM) closed at $86.73 per share. If you previously paid $84 per share for 100 shares of XOM and on March 30, sold a July 87.50 call for 2.31 ($231) your net basis would be $81.69 ($84.00 - $2.31). So is this risk associated specifically with covered calls? It is not. If you just own the stock, your basis is still $84, so covered call writing reduces your market risk.

It makes sense to structure your covered call properly to ensure that you maximize gains while reducing risks. Some suggestions:

1. Exercise. Remember that exercise is a possibility. Don't write covered calls unless you are willing to get exercised. This can happen any time the call is in the money, and you have to be willing to accept that. The most likely day of exercise is the last trading day, but it can also happen on or right before ex-dividend date … or any time for that matter.

2. Strike. Pick a strike with your basis in mind. It makes no sense to write calls at a strike below your basis. In the event of exercise, this will mean you end up with a net loss on the stock. Always pick a strike that will result in a net gain. In the XOM example, the 87.50 call was not only well above the basis of $84; it was also out of the money based on the March 30 closing price.

3. Expiration. Go for shorter expiration, not longer. When you review the dollar value of different options, you realize that further-out expirations get more money. Even so, you are going to make more return picking expirations within two months or less, even though the dollar value is lower. This is better for two reasons. First, it means having your capital tied up for less time. Second and more important, your annualized return is going to be higher because time decay as accelerated during the last two months. So you are generating more profits with six 2-month expirations than you would with one 12-month.

4. Dividends. Remember the dividend. Your dividend yield can represent a major part of overall income from covered call writing. So when selecting among several stocks that are fundamentally the same, remember to also compare dividend yield.

5. Stock selection. Remember the fundamentals. Pick stocks that are fundamentally solid. It makes little sense to go with high volatility and market risk even though that translates to higher option premium. The market risk of volatile stocks is too great, and don't buy stocks solely for the covered call opportunity. Focus on companies with strong historical trends and a record of increasing profits, steady or declining debt ratio, growing dividend yield, and consistent P/E.

6. Forward rolling. Roll forward to avoid exercise, but only when it makes sense. You can roll out of one short call and into another that expires later. But at times it is more profitable to simply accept exercise and then go on to the next strategy. It might be minimally profitable to keep yourself on the hook until a later expiration. Compare outcomes before taking any step to avoid exercise.

7. Recovery strategy. Create a recovery strategy. What will you do if the stock price does decline below your net basis (cost of stock minus call premium)? You need a recovery strategy. This may include writing additional covered calls above your net basis, selling puts, or just taking the loss and seeking a similar covered call strategy in a stronger company. For example, you could convert a short call position into a collar if the stock price began to decline. In the XOM example, there was a very healthy gap between the call's 87.50 strike and the original basis of $84 per share, 3.5 points. A July 85 put was valued at 2.47 on March 30, 2012. If the stock price were to begin slipping, this protects against a net loss and builds in a one-point profit in the event the price falls below $85 per share. However, the put is 0.16 higher than the premium received for the call; so converting to a collar would be wise only if it looked at though the price was on a steep decline; it is a mitigation strategy.

Covered call writing is a great strategy, but it isn't a guarantee of profits. You need to consider these points to avoid unsatisfying surprises. You will discover, however, that when done right, you will enjoy profits consistently without accumulating losses.

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