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Options Trading: Some Covered Call Basics

By  Dec 31, 2009

Topics: Finance & Investing

Even if you have heard about covered calls, some important caveats apply and are worth reviewing. It’s not simply a matter of selling the richest contract …

Here is the basic way that the covered call works:

You own 100 shares of stock. If you sell a call, it is covered in the sense that exercise can be satisfied by delivering your shares at the strike. For example, if you sell the call with a strike of 50 and that call gets exercised, you give up your 100 shares at $50 per share – even if the current market price is much higher.

 Some additional matters equally important to remember:

 1. Pick a strike above 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 programs in a loss upon exercise.

2. Compare dividend yield in picking the best covered call strike. 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, remember to think about the 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. As a result, 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 – and offsetting possible added gains with a higher and unexpected tax consequence. Before rolling to a later expiration, check the rules.

5. Remember to compare not only premium, but also 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. Don’t b e fooled by the higher dollar value; 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.