The covered call option strategy involves buying shares of stock and selling call options against those shares. The purpose behind writing calls is to generate income from the sold call options with a bonus if the stock price increases in value. A good covered call stock can be a company from almost any market sector. You are looking for stocks and associated options that fit certain criteria, giving you the chance to earn the desired level of profits on your covered call writing.
Stock Price Prognosis
Writing covered calls works best with a stock price that stays level to slowly rising. The typical covered call trade will be open for two to three months. Although predicting the future can be difficult, stocks for covered calls should be selected to avoid potential price negative events. For example, you may want to avoid a stock that will report earnings during the period while the trade is in effect. You can also review the general price history or a stock for the last year or so to see if there were any points in time or periods when the share price dropped dramatically. These would be warning signs against using the stock as a basis for covered call writes.
Call Option Pricing
The prices of the call options must have enough value to provide an acceptable return on the covered call trade. The option value is derived from the expected volatility of the underlying stock. A boring, steady stock will have cheap options and not give much of a return on a covered call. A more volatile stock will have more expensive options, putting more money in your account when you sell the calls. Plug stock price and option values into the covered call expected return calculator on your brokerage account website to compare how much you can make on a covered call trade with different stocks.
Watch the Dividend Dates
High-dividend stocks can result in less than desired covered call returns if the trade is in effect when a stock goes ex-dividend. It is tempting to try to capture the dividend as well as the call option premium with a covered call trade, but it is very likely the call could be exercised, calling away the stock before you earn the dividend, reducing the total return on the trade. Compare the potential covered call returns for the periods between dividend payments with having the trade open when the dividend is paid.
Secret Tip: Implied Volatility
A quick way to gauge the profit potential of a covered call using a specific call option is to look at the option's implied volatility -- which should be listed on the call options price page on your brokerage account. The implied volatility percentage is a good estimate of the annualized return of a covered call trade using that call option. Higher volatility means higher potential return with the trade-off of a greater chance the stock will go down and the covered call will end up a loser. You can screen stocks by call option implied volatility to get a list of potential stocks to use with the strategy that will give the returns you are looking for in your trading.
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