Thursday, January 13, 2011

How to write a covered call

Writing, also known as selling, a covered call is easier than you think.

A covered call trade is an option trade. All major brokers like Schwab or Fidelity can provide you with the ability to trade an option.

What is a covered call? In order to sell something you have to own it. Selling a covered call requires that you own at least 100 shares of a stock. Once you own 100 shares, you can sell to another person the option to buy your shares.

A call option is a contract that consists of:

  1. the right but not the obligation to buy your shares
  2. a strike price which is the price the buyer has to pay you for your shares if they decide to exercise their right to buy them from you, and
  3. An expiration date after which either the contract is fulfilled and they buy the stock from you or the contract is void and you retain the shares.
For instance, I own 100 shares of XYZ stock and the price per share is $10. Another person would like to buy that stock from me at $11, which is the strike price. $11 per share is a 10% gain for me. The buyer thinks the stock will go to $15 per share and $11 a share seems like a bargain.

That person pays me $.10 per share for the right to buy my stock before the option expires. I think that a 10% percent gain if I sell my stock at $11 is good. Either way, I keep the $.10 the buyer paid me for the option. If it all works out well, I get an 11% gain in 1-6 months. The worst scenario is I am stuck with the stock because the buyer does not want to pay $11 per share.

In order to make an option trade, you will have to obtain approval by your broker to trade in your account. At this point, I do not want to confuse you about why the broker will approve or disapprove your account for option trades. If you tell your broker that you want to trade covered calls, it is highly likely your broker will approve your account. 

To pace your call option trade,  bring up the option order trade screen and select "sell to open."  Next you have to determine how many contracts you want to sell.  One contract equals 100 shares.  If you want to sell calls on 1,000 shares that would be 10 contracts. Select if you want to sell at the market price or a limit price.  I always sell at a limit price because options are volatile and I want to try for a 10% gain.  Like all trades, your entry will be reviewed before you commit and click on "place or submit your order."  Check the status of your trade on the order status screen.

Do not get caught up in trying to understand all the parts of the option market.

Learn about covered calls and covered calls only. Look at every stock you own and use your broker's website or personal service to learn what someone is willing to pay you for your stock. Calculate the gain you would get by selling your stock at a price higher than you paid and the amount the call buyer pays you. Decide if you really are willing to sell the stock at the contracted price.

Readers of this blog will appreciate that as income investors, we only sell covered calls when the strike price is greater than our cost basis. We rarely sell a call with more than a 3 – 4 month expiration date. Finally, we hope that each time we sell a call on our shares our minimal gain will be 10% or we will sit with the stock. Therefore, we need to be happy owning that stock. Again, if you follow my cash flow strategy, you know that we buy stocks that pay us some income and that means we rarely mind having to continue to own the underlying stock but we really like a 10% gain so we are frequently willing to let someone else buy our shares. There is always another stock to buy.  If our call expires and we no longer like the stock, we sell it and move on but we keep that call premium and often times a dividend.


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