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Options Trading: A Quick Look at the Covered Call

Posted February 3, 2011

Topics: Finance & Investing

Covered calls are among the safest, most conservative, and profitable of option strategies. There is even a way to eliminate the downside risk without added costs. A collar enables you to create both a covered call and an insurance put; the cost of the put is covered by the income from the covered call.

The covered call consists of two primary parts:

First you own 100 shares of stock. Second, you sell a call, which provides the buyer on the other side of the trade the right to call away your 100 shares at the fixed price. This “cover” of the call eliminates the risk of going short, while providing you with income from selling the call. It may mean losing out if and when the stock price rises far above the call’s strike. For example, if you bought stock at $35 per share and it is now worth $39, you might consider selling a 40 strike call. You get to keep the income you receive, plus making a five-point capital gain if the call is exercised. But if the stock price rises well above the 50 strike, you still have to give up shares at 50.

Remember these basics:

1. Pick strikes higher than your basis. Always pick a strike price that yields a capital gain, not loss, if the covered call is exercised. For example, if you bought your stock at $48 per share, sell a call with a strike of $50 or higher. If you sell the 45 strike and it’s exercised, you lose 3 points in the stock ($48 basis minus $45 strike price). So if you sell the call for 2 ($200) in this example, your net loss is $100. There is no point in writing a covered call that creates a loss upon exercise.

2. Watch dividend yield when picking stock for covered call writing. >One of the most overlooked aspects of covered call writing is dividend yield. This represents a major portion of the overall covered call strategy. So if you write calls on a 6% yielding stock, versus calls written on a 2% yielding stock, your dividend income is three times higher. The yield can also be used as a criterion for deciding which of your portfolio holdings to use for the covered call strategy.

3. Be willing to accept exercise (but know how to roll). When you write a call, you’re selling the option rights to someone else. This means that if the call is in the money, it will be exercised and your 100 shares will be called away. Be willing to accept this as one possible outcome. At the same time, know how to roll forward to defer or avoid exercise. The disadvantage of rolling is that it extends the time you have until expiration.

4. When you roll forward, be aware of the potential tax consequences.A “qualified” covered call lets you claim long-term capital gains treatment on stock. But an unqualified covered call can toll the long-term count. So stock that has appreciated considerably could be fully taxed as short-term. It is easy to make the mistake of replacing a qualified covered call with an unqualified one as the result of rolling forward – and offsetting possible added gains with a higher and unexpected tax consequence. Before rolling to a later expiration, check the rules.

5. Compare premium and time. Shorter-term calls get higher yields. You are going to get a much better annualized return with calls having a shorter time to expiration. The effects of time decay make one-month and two-month covered calls much more profitable than those expiring further out. The higher dollar value of longer-term calls is deceptive; annualize the return to make valid comparisons between expirations. To annualize, calculate the return (premium of the call divided by the strike price); then divide by the months until expiration and multiply by 12. This gives you the annual equivalent.

 6. Also take a look at the collar.A collar is a covered call plus an put. The cost of the put is offset by profit from the call. This offsets the downside risk of the stock without adding costs. The short call can be exercised, allowed to expire, closed, or rolled forward. In any event, if the stock price declines below the put’s strike, every point lost in the stock is offset by a point fog ain in the put’s intrinsic value.

Michael C. Thomsett is an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Trading with Candlesticks. He also contributes to the CBOE newly-formed blog.