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If you subscribe to our terrific service, Options Advantage, you may know that using covered calls is a great way to generate regular monthly income from the stocks you already own. But how do you know which stocks benefit most from this strategy, and which call options to pick?
I’ve made my share of mistakes in options, and over the years I developed my own personal Four Commandments for Selling Covered Calls. I want to share them with you so you can avoid the expensive mistakes I’ve made.
Here’s a quick primer on what a covered call option actually is. If you own a stock, you can sell the right for someone to buy the stock from you at a given price (“strike price”) on or before a certain date (“expiration date”). That makes you the call seller. In exchange for the right to buy that stock from you at a certain strike price on or before the expiration date, the call buyer will pay you some money, called a “premium.”
If the stock trades at or below the strike price at expiration, you keep both the stock and the premium paid to you. Hooray! If the stock trades at or above the strike price any time at or before expiration, the call buyer can “call” the stock away from you, forcing you to sell it to him at the strike price. Boo!
Hopefully, if it is called away, it is called away at a time when the stock trades for less than the strike price plus what you received in premium, meaning you could buy the stock back for less than it was called away for plus the premium earned.
Today I want to highlight three plays that illustrate exactly how to use this strategy, because I’m using them myself on these same exact stocks.
I have four criteria for selling covered calls:
1) Use a stock I’ve tracked and want to own.
By tracking certain stocks, I often notice patterns in its trading. These aren’t hard and fast, but often times I will notice a stock tends to trade in a given range. Range-bound stocks can be good for selling calls against. It means it is less likely to get called away.
I want to own the stock, so being range-bound means the stock is likely undervalued that the market hasn’t seen potential in yet. Perfect. I like value stocks, and will sell covered calls to generate returns on it while I wait for the market to find the value I see.
2) Sell calls against half the position.
I don’t want to sell calls against my entire position. If something should happen that pushes the stock well above the strike price, I would hate to lose out on all that upside. So I only sell against half my position.
3) Have a target return and sell in bulk.
What kind of return do you want to see from a covered call? Generally speaking, I’ve found that a 2% return for a 4-5 week period before expiration is pretty good. That means that if you did it over and over again, you’d get something like a 20% annualized return. That’s good.
4) Pick stocks that aren’t too volatile.
The more volatile a stock is, the higher its premium will be. So you want stocks that show some degree of volatility but not too much.
Shuffle on over to Options Advantage for some ideas. Try it out for a month or look over other articles on covered calls to see how this strategy works.
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