Covered calls are incredible cash cows. It is difficult to avoid double-digit returns if you focus on short-term contracts slightly out of the money. Writing several of these per year and waiting out expiration (or closing at a profit and replacing) is clearly one of the best conservative strategies. For anyone willing to accept the risk of having shares called away, covered call popularity is well deserved.
However, the strategy only works well if a few smart rules are observed:
- Pick stocks for fundamental value and not just for maximum covered call income. One of the great problems with writing covered calls on volatile stocks is the net loss that occurs if the stock price plummets. For this reason, you have to pick stocks of companies you believe are stable and safe.
- Select strikes above your net basis. If and when exercised, you want to make sure you end up with a net profit and not a net loss. Be sure the call strikes you pick are higher than the price you paid for your 100 shares. Also be sure you understand how the moneyness of the option affects premium and likelihood of exercise.
- Focus on short-term expiration. Although the dollar value of later-expiring calls is higher, the annualized return is always higher with short-term calls due to accelerated time decay. Annualize returns to make valid comparisons. (Divide the return by the months until expiration, and then multiply by 12. Also, calculate based on dividing the call premium by the strike price, not be current or original value of stock.)
- Accept exercise if and when it happens. You have to be willing to have this as one outcome in order for the strategy to work. You can close or roll out of positions to avoid exercise, but compare the outcomes. It often is most advantageous to let your covered call get exercised.
- Be aware of ex-dividend dates and earnings announcements that will come up before expiration. Price reaction to these events may affect the value of the short call; and early exercise is possible right before ex-dividend date for any short calls in the money.
Remember, covered calls can also mean lost opportunity if you use the wrong stocks. Higher volatility means richer premiums, but also higher risks. There is a lot to consider in selecting and managing a covered call strategy. To discover ways to easily and quickly create low-risk option plays, check Born to Sell
Always be willing to do your homework and pick not only the best options trades, but also the best stocks as a match for those trades.