Commonly referred to as the "most conservative option strategy available," this technique has cost uneducated investors billions of dollars since options were invented. Do not get me wrong: writing covered calls can be a very profitable strategy when implemented correctly. The Covered-Call and the Naked-Put (an equivalent strategy) are consistently the most profitable strategies. It is all in the technique!

Generally, covered calls are written on stock an investor holds in his portfolio. The concept is to produce cash flow by selling premium for income while obtaining downside protection. The underlying stock can be held in either a cash or margin account. The advantage of trading on margin is that the potential return on investment is doubled. The disadvantage of using margin is that additional capital (margin call) may be required in the account if the portfolio value falls below a certain percentage.

Many investors are very successful in this strategy because they are not greedy. They understand the "magic" of compound interest and strive to consistently increase the value of their investment portfolios each month. Others constantly lose money by implementing the technique incorrectly.

The term "covered" is used when describing the sold (short) calls in this strategy because the investor owns the stock on which he is writing the calls. For every 100 shares of stock the investor owns, he can "write" one (1) call-option contract. Typically, investors will pick the next strike price above the current price of the stock to maximize the potential return on investment. A conservative investor will pick an in-the-money (ITM) strike price, choosing an acceptable return that offers reasonable downside protection. Aggressive investors tend to focus on the higher returns of using out-of-the-money (OTM) strike prices at the expense of downside protection. These OTM positions do offer greater "potential" rewards, but depend on an increase in price by the underlying stock and do not really benefit from writing the call.

Return On Investment

The target-yield or return on investment (ROI) for covered calls is determined by two circumstances: Return if Called (RC), and return not called (RNC). Most traders use the RNC to evaluate plays since there is no assumption made on the movement of the underlying equity. To calculate the return, you take the net premium received and divide it by the cost basis. The cost basis would be the price paid for the stock, minus the premium received; this is the maximum amount of equity required for the duration of the play (not using margin). We use generally accepted formulas to calculate the return as shown below.

For an ITM covered call, the net premium would be the option premium received minus the difference between the cost of the stock and the strike price. ITM RNC will be the same as RC, since the sold strike is already "in-the-money," and is the maximum return possible.

ITM example:

XYZ @ $12.00, strike = $10.00, option premium = $2.50
Net premium = 2.50 - (12 - 10) = 0.50
Cost basis = 12.00 - 2.50 = 9.50
RC = 0.50/9.50 = 5.26% after multiplying by 100.
RNC = the same.

For an OTM covered call, the net premium for a RC calculation would be the option premium plus the difference between the cost of the stock and the strike price and assumes the stock price will move up to the sold strike! An OTM RNC calculation uses only the option premium and assumes the stock price remains unchanged.

OTM example:

XYZ @ $12.00, strike = $12.50, option premium = $1.00
Net premium = 1.00 + (12.50-12) = 1.50
Cost basis = 12.00 - 1.00 = 11.00v RC = 1.50 / 11.00 = 13.64%
RNC = 1.00 / 11.00 = 9.09% (You do not get the benefit of the stock price moving up to the strike price).

Successful investors choose ITM covered call candidates as the goal is to obtain the highest probability of making an acceptable (and consistent) return.

Covered-Call Comparisons

Let us look at an example. An investor holding a $16 stock could possibly write three different calls: the $15 call for $1.75; the $17.50 call for $1; and the $20 call for $0.50. Notice the ITM the position ($15 strike price) offers a maximum return of 5.26%, even if the stock price dropped a $1.00. Generally, when comparing covered call positions, investors concentrate on the return achieved if the stock price remains unchanged. In this manner, no assumption is made regarding the future movement in the underlying equity and the overall position reflects the benefit of just selling the call.

The cost basis is important as it identifies the break-even point and the amount of downside protection. As you can see the $17.50 strike offers a slightly higher "static" return but only half of the downside protection of the $15 strike. Clearly, the $15 strike offers the best of both worlds; a reasonable return with acceptable downside protection.

Why choose OTM positions? It simply depends on your risk-reward tolerance. If you are that good at picking stock movement, wouldn't it be better to just trade the stock instead of capping your potential profits with a covered-call position?

Writing Covered Calls: The Drawbacks

Assume you bought a stock at $50 that had fallen substantially (to the $20 range and you were trying to recover some of your losses by writing OTM covered calls. If the stock unexpectedly rises above the sold strike price (say a $30 strike) at expiration, the issue would be called away and you would have locked-in a loss.

Or, assume you bought a stock at $10 a few months ago and now you think it is going to $50. You want to hold it for the long term but you would also like some downside protection. You sell some short term OTM calls to generate cash flow but the stock climbs very quickly and is called away. Not only did you lose your stock, but incurred a short-term capital gain as well. You did make a profit but it is now taxable at a higher rate.

Consider the following examples:

Let us say you bought the stock in the chart above to hold long-term and you hope it will return to its highs at $50. The stock has done nothing over the last two months and you decide to write the October $7.50 call for $1.00 while you wait for the stock to find a bottom. There is only three weeks left in the option cycle so you feel confident you will not be called.

Here is what happened to that OTM position:

You wrote those covered calls a couple days before the stock caught fire on an analyst upgrade and began a rally that could take it to the $30 range. Seller's remorse sets in because the stock has risen 50% from the price at which you wrote the calls. You made a nice profit on the call but in reality, it was less than half of what you could have made simply holding the stock. If you are bullish on a company and do not want to lose the stock DO NOT sell covered calls. Many investors discard the covered call strategy because they cannot stand to limit their profits.

There are worse things that can happen to a covered-call writer than taking a small profit and missing out on a bigger one. A common idea is to write covered calls to minimize losses on stocks that have become bearish and are trending down. I cannot tell you how many times I have heard the phrase: "I will just write calls on it until I get my money back." This is an interesting concept but a failing strategy in my opinion, as the attempt to recover lost share value often results in a locked-in loss. If you become bearish on an issue, it is usually best to simply buy back the calls and sell the stock. Why tie up your money in a low-probability effort at recovery.

If a stock drops $20 or $30, how many months do you have to write calls on it until you get your money back? Assume the stock has fallen from $50 to $25 and you don't want to be called-out and incur a loss. With a $25 stock, you can expect the OTM option premium to sell for about $1. Remember, you don't want to be called away so you have to write OTM calls. Thus, in the best case scenario, you will have to write OTM calls (at $1 each) for 25 months AND NOT BE CALLED OUT in order to just BREAK EVEN. That is 25 months of more risk to achieve a break-even exit. Your risk is not only being called-out but also the potential for a future decline in the stock price. How many months would you have to write covered-calls on the stock below to recover your money if your cost basis was $50?

There are no covered calls you can write on a $1 stock.


Is it really a conservative strategy?

The Covered Call strategy is not foolproof as there is risk in all trading. It does have less risk than outright stock ownership as the premium received reduces the cost basis in the underlying issue. Still, whether the covered-write strategy is applied short-term or longer term, it requires a neutral to slightly bullish outlook on the underlying equity and the overall market. As with stock ownership, you are still exposed to the risk of a drop in the stock price. Almost every week there are several stocks that drop double-digits on a negative news event. The premium you receive for writing a covered call may not be enough insurance to protect yourself against this risk.

There are ways to profit from the covered-call strategy with minimal risk.

I favor a very conservative approach and in my opinion, that is the only way to use the covered-call strategy. I always recommend writing ITM covered-calls as we are not interested in stock ownership or bullish movement, but prefer the higher probability of making a low yet reasonable return. The fact that we really cannot predict stock movement reinforces my reasoning for choosing to hedge stock ownership with ITM covered writes.

I generally target a monthly return near 5%. The ITM covered-call strategy usually requires a "buy-write" order to open the position at or near the listed net debit (cost basis), since trying to leg-in (buying the stock and selling the call later) may only see the overvalued premium disappear.

There are several things you want to remember when using covered calls.

1. Never buy a stock you do not want to own.
2. Never write calls on a stock you don't want to lose.
3. Never write calls as a cost-recovery tool on a stock you do not want to lose.
4. Always write covered calls on STOCK YOU BOUGHT FOR THIS PURPOSE.
5. Always plan on being called-out EACH month.
6. Always write in-the-money calls.
7. Always write calls on bullish stocks.
8. Always use sound money-management techniques.

A Winning Strategy!

Is there a correct way to write covered calls? Here are two samples of ITM covered writes:

On October 8th you could have written a November $35 call on BHP for $3.25. The call is already $2.32 in the money so your net if called away is 93 cents. If done on margin the return if called is 5% for a 6 week position. Your downside protection is $3.25 below the current stock price at $37.32. That means BHP would have to fall under $34.07 (-8.7%) before you lose money. That ITM premium received is insurance against an unexpected decline.

Another example would be the Analog Devices (ADI) November $55 call, currently $4.10. The call is $2.72 ITM so your net if called would be $1.38. If done on margin your return would be 5% for six weeks. Your insurance is $4.10, which means ADI would have to decline below $53.62 (-7.1%) before you lose money.

Earning 5% per month may not seem like "big" money but 60% per year is definitely better than the average investor's return for almost any other strategy. Many investors lose sight of the magic of compound interest and start to focus on excellent single transaction returns. In short, they become greedy!

Again, the key points in this strategy are as follows:

1. Use only on stocks you buy for this purpose
2. Write in-the-money calls to minimize risk.
3. Plan on getting called-out every month.
4. Write calls only on bullish stocks.
5. Maintain stop-losses on the underlying equity whenever possible.

There Is Risk In All Trading

Remember, there is no "Holy Grail" in option trading. Even with this "conservative" strategy, it is possible to lose money. The probability of loss is much lower with covered-calls but unforeseen events do occur. Whenever possible, maintain a stop-loss on the underlying issue to limit losses. Should negative news come out during the day, or if the stock changes character, trading stops may save you from needless loss and months of attempting to recover lost capital

In the event of a catastrophe like the EXAS event in the chart above, there is nothing that will help. To reduce the impact of these unavoidable events, we recommend that you never invest more than 3% to 5% of your overall portfolio in one stock. This is an important concept of money management -- so that one stock will NOT have a significant impact on your overall portfolio value. No one knows what a particular stock is going to do in the future unless they have "insider" information. Therefore, you do not want to have "one ship that sinks the whole fleet."

Even with one or two unanticipated, catastrophic events in a year, I have found that a diversified ITM covered-call strategy, when used in a disciplined manner, can generate a 30% - 40% yearly return. The ITM covered-write strategy is for conservative investors who prefer to target the high probability of obtaining an acceptable return, which correlates with a low risk-reward tolerance. Greed is for those other guys!

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