How to write a covered call option
Writing a covered call allows you to take a take a moderately bullish stance on a stock. By writing a covered call, you can earn a solid return on your investment if the stock stays at its current price. Even if the stock declines slightly, you can still make a profit on the position.
The ability to earn without an upswing in price is what you gain by writing a covered call. What you lose is the ability to make a massive profit if the stock has a dramatic gain. When you write a covered call, your maximum profit is capped.
This how-to will offer some general guidelines for choosing opening covered call positions.
Choose a stock.
Remember that a covered call is a primarily neutral stance on a stock. If you expect a stock to skyrocket in price, you would not want to write a call against it. A good candidate for a covered call has solid, stable fundamentals and a beta less than one.
ETFs such as the NASDAQ index tracking stock, QQQ, are often a good choice for covered calls because of their relative stability.
Choose a strike price for the call.
The maximum profit you can make on a covered call is found by subtracting the purchase price of the stock from the strike price of the call and adding the call premium.
Selling a call with a very high strike price will mean that you may earn more money if the stock goes up, but you will collect a lower call premium, which means less profit if the stock stays at its current price. Getting a higher call premium will help defray the loss if the stock decreases in value.
Hence, choosing a strike price means finding a balance between earning a high call premium and leaving the stock room to move. If your stance on the stock is moderately bullish, you may want to sell a call that is out of the money. For example, you may wish to sell a 15 call on a stock that is trading at 12.5. For a truly neutral stance, sell an at the money call, i.e. a call whose strike price is as close as possible to the current stock price.
Time is also a factor in choosing which call to sell. By selling a call with a later expiry, you will gain a higher premium, however the underlying stock price is more likely to change over a longer timeframe. Selling a call with an expiry in the near future means earning a lower premium. In general, I like to sell calls one month out, e.g. a January call in December.
Open the position.
If you already own the underlying stock, you can turn your position into a covered call by selling a short call on that stock. If you do not already own the stock, it’s best to open the position as a covered call by purchasing the stock and selling the call all in one trade. If you don’t know how to execute the trade, try calling your broker’s help desk.