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7 Points: Covered Calls Yield Double-Digit Returns But A Few Guidelines Apply

Can you earn double-digit annualized returns in a conservative strategy? Yes; the covered call is one of the few strategies that can out-performs owning stock.

You earn profits in three ways: from capital gains at exercise, premium paid for selling the call, and dividends. You can also lose money with covered calls, however. If the stock's price rises above strike, you lose the gains you would earn by just holding stock; and if it falls below your net basis (cost of stock less option premium), you end up with a paper loss. So covered call writing makes sense only if you are willing to make the trade-off between certainty and risk.

Seven guidelines improve the chances that your covered call will be profitable:

1. Pick a strike price above your basis. It makes no sense to pick a strike below basis; at exercise you would have a capital loss. The strike should always be higher than your original cost of stock.

2. Pick the most advantageous expiration. Be aware of time decay. Value falls rapidly in the last two months, so a covered call one to two months away from expiring will fall in value at the fastest clip. This is an advantage. When you buy options, time is the enemy. When you sell, time is your friend.

3. Don't overlook dividend yield and timing. The dividend yield often is the largest portion of profit. In making comparisons, look at option premium and dividend yield. Also, pick an expiration that comes after the next ex-date so you will earn the quarterly dividend. Also be aware that the period immediately before ex-dividend date is the most likely time for early exercise of in-the-money short calls. So avoid writing calls in ex-dividend month.

4. Pick the stock based on solid fundamental strength. Picking the right stock should use smart fundamental criteria. You can earn higher premium on exceptionally volatile stocks, but there is also a higher risk. Would you buy those stocks anyhow? Be guided by smart stock selection, and not by option profits.

5. Know when to accept exercise and when to roll forward. When your covered call is in the money it will be exercised if you take no action. Depending on what you earned in premium and how much capital gain you will earn, it sometimes makes sense to let exercise occur. At other times, you can avoid or delay exercise by closing the original position and replacing it with one expiring later (and possibly at a higher strike). It is important to look at the complete outcome to make the best choice.

6. Devise a recovery plan in case the stock's value declines. When you buy stock, you should identify a bail-out point. This still applies if you also writer a covered call. The profit from the call reduces your net basis, which is the first point in your recovery plan. If you want to write a second covered call, remember to pick a strike that is still higher than your net basis. You want to program in net profits and not net losses.

7. Finally, time entry into a covered call at a trend peak. Sell the call at the top, when price is at resistance or has moved through with a gap. This is the best possible timing, expecting the price to retreat so the call becomes profitable. Plan to buy to close when the price has declined to proximity with support.

Covered call writing is potentially your portfolio cash cow. However, you have to be willing to accept exercise and also to remember to pick stocks based on smart criteria. If you follow those basic guidelines, you can earn a conservative annualized double-digit return.

Michael Thomsett blogs at TheStreet.com, Seeking Alpha, and several other sites. He has been trading options for 35 years and has published books with Palgrave Macmillan, Wiley, FT Press and Amacom, among others. His latest book is Making Money with Option Strategies