How to write a covered call option

Looking for a neutral or slightly bullish position?

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.

Instructions

Step 1

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.

Step 2

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.

Step 3

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.

You will Need

• A brokerage account.

• Enough buying power to purchase the underlying stock.

Tips & Warnings

• Remember that your maximum profit is capped when you write a covered call! Even if the stock doubles, you will only make a modest return.

• Note that the maximum loss on a covered call is the stock price less the call premium, which is a significant risk. You will only incur this maximum loss if the stock goes to zero.

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