Writing covered calls for income is an attractive strategy since it can yield profits in a variety of different markets. Like many option trading strategies, the trade can be made to be more conservative or more aggressive.
To review, a covered call is constructed when you own 100 shares of an optionable stock and you sell someone else the right to buy those shares from you at a specific strike price by 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 stock at the agreed upon price.
The most conservative approach is to write the covered call in the money, or at a strike price below the current share price. The cash premium you receive will consist of the amount the option is in the money as well as additional premium based on time value (providing the strike price isn’t too deep in the money). You’ll receive less time premium (net income) with this approach, but the advantage is that you’ll gain much more downside protection since the stock will have to drop a lot farther for you to lose money (it would have to trade below the the strike price less the amount of time premium received).
Writing the call at the money, or at a strike price that’s very close to where the stock is currently trading, will give you more time premium but less protection. And writing the call out of the money by choosing a strike price higher than the current share price will give you the least amount of downside protection but will produce the largest profit if the stock trades significantly higher.
It’s important to realize that while the original strike price chosen is of critical importance to how the trade plays out, there are additional adjustments and modifications you can also make to the covered call position once the trade has been set up. Here then are three such trade adjustments to maximize your covered call income:
- 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 on in the option cycle. If the maximum gain on the trade is 4{da74ea48cec7d1c659e4125ffe517180d7bd6cbbe5631d32f11d21c45900f39b}, for example, but the stock makes a big move early on so that the trade is already up 3{da74ea48cec7d1c659e4125ffe517180d7bd6cbbe5631d32f11d21c45900f39b} in the first week, you should definitely consider closing the position early. Not only do you lock in your profits (and for a higher annualized return), but you also free up your funds for other covered call opportunities.
- Roll the call option down if the underlying stock trades down sharply. This one can be a bit tricky to pull off. If a covered call trade really begins to move against you, it might be best to just close the position and cut your losses. But if you’ve chosen a quality company in the first place and the stock has fallen but isn’t in a complete meltdown, you can always roll the call down, repurchasing the call you originally sold (it will be worth considerably less now) and then re-selling another one at a lower strike price. This will net you more income (which equates to additional downside protection) but it does come at a price–if the stock rebounds sharply, you’ll most likely be whipsawed into a loss.
- If the stock trends lower, close the position early and wait. This is similar to Example #2 above, but works better on stocks that have drifted lower rather than those that have fallen sharply. It also works better as part of covered call strategies used by investors with long term portfolios who are in no hurry to sell their stock. If a stock is steadily drifting lower so that the original call sold has lost a great deal of its value and with plenty of time remaining before expiration, you might want to buy back the call and wait to see what the stock does next. If the stock begins to rebound, you can resell another call at the original strike price once that call has increased in value again. If, however, the stock continues lower, you can eventually write the new call at a lower strike price, a sort of slow motion rolling down of your original covered call trade.
Covered call writing, when practiced prudently, is a conservative strategy that can generate attractive streams of income. It’s also a flexible strategy that can be modified to maximize that income. But it is not without risk and it shouldn’t be approached without due diligence or an awareness of the potential pitfalls.