Writing covered calls for income is an attractive strategy as it can generate profits in a variety of different markets. Like many options trading strategies, trading can be made more conservative or more aggressive.
To review, a covered call is constructed when you own 100 shares of a stock option and sell someone else the right to buy those shares from you at a specific strike price on a specific expiration date. If, at expiration, the shares are trading above the strike price, the call option will be exercised and you will be required to sell the shares at the agreed price.
The most conservative approach is to write the covered call at the money, or at a strike price below the current share price. The cash premium you receive will consist of the at-the-money option amount, as well as additional premium based on time value (provided the strike price is not too deep in the money). You’ll receive a lower time premium (net income) with this approach, but the upside is that you’ll get much more downside protection, since the stock will have to fall much further for you to lose money (it would have to trade below the exercise price minus the amount of time premium received).
Writing the call option at the money, or at a strike price that is very close to where the stock is currently trading, will give you more time premium but less protection. And writing the out-of-the-money call by choosing a strike price higher than the current stock price will give you the least amount of downside protection, but produce the most profit if the stock trades significantly higher.
It is important to realize that while the original strike price chosen is vitally important to the development of the trade, there are additional adjustments and modifications that you can also make to the covered call position once the trade has been established. Here are three such business settings to maximize your income from covered calls:
- Close the position early if the underlying stock makes a big move higher. This is an especially good idea if the stock makes a big move early in the options cycle. If the maximum profit on the trade is 4%, for example, but the stock makes a big move early on, so that the trade is already up 3% in the first week, you should definitely consider closing the position early. . Not only does it lock in your earnings (and for a higher annualized return), but it also frees up your funds for other covered calling opportunities.
- Roll the call option down if the underlying stock is trading sharply lower. This one can be a bit tricky to pull off. If a covered call trade really starts to move against you, it might be better to just close the position and cut your losses. But if you’ve picked a quality company in the first place and the stock has dropped but not completely crashed, you can always cut the call down and buy back the call you originally sold (it will be worth considerably less now) and then resell another at a lower strike price. This will earn you more income (which amounts to additional downside protection), but it comes at a price: if the stock rallies sharply, you will most likely be at a loss.
- If the stock is trending lower, close the position early and wait. This is similar to example #2 above, but works better on stocks that are down more than stocks that are down sharply. It also works best as part of covered call strategies used by investors with long-term portfolios who are in no hurry to sell their stocks. If a stock is steadily going down so that the original buy sold has lost a lot of its value and there is a lot of time left before expiration, you may want to buy the buy back and wait to see what the stock does next. If the stock starts to rally, you can resell another call option at the original strike price once that option has risen in value again. However, if stocks continue to drop, you can eventually underwrite the new call at a lower strike price, a kind of slow move down from your original covered call trade.
Covered call writing, when practiced wisely, is a conservative strategy that can lead to attractive income streams. It is also a flexible strategy that can be modified to maximize that income. But it is not without risk and should not be approached without due diligence or an awareness of the potential dangers.
