Last week, I discussed the idea of selling put options on stocks you might want to own. We looked at why the strategy was a great way to generate consistent income with relatively low risk.
Today, I want to talk about the other options selling strategy that I recommend — covered call writing.
In many ways, covered call writing is like the mirror image of cash-secured put selling. But it is done with stocks you ALREADY own.
And actually, I consider covered call writing — as long as it is done properly — to be the absolute simplest, most conservative way to use options in a portfolio.
It is also a great strategy to consider right now, with the stock market once again hitting new highs.
Because, in its essence, covered call writing is a moderately bullish strategy. And in the case of an income portfolio, I actually think it works best if the market remains relatively flat or even pulls back a bit in the shorter term.
When You Write a Covered Call, You’re Basically Trading Upside for Income
To understand why that is, let’s do a quick rundown of the strategy.
Call options are contracts that allow investors to buy a given security at a given price (the “strike”) over a specified time frame. Each options contract covers 100 shares of the security, known as a “round lot.”
Therefore, when you write a call, you’re selling this right to someone else and collecting the premium — the price that the investor is willing to pay for the option — in return.
And again, the reason this is called covered call writing is because you are writing calls on stocks you own.
Yes, it is entirely possible to create and sell a call for a stock you don’t own, but I DO NOT recommend doing it. Known as “naked” writing, it literally leaves you exposed to lots and lots of risk.
OK, so let’s say we write a covered call on 100 shares of stock we own.
As I already mentioned, we will first get the premium paid (minus commissions) deposited into our account. This is ours to keep no matter what.
Then, we wait and see what happens between now and the time the contract expires.
If the stock price fails to rise above the strike price of the contract, the investor who bought our call option will let it expire worthless. We get to keep our stake in the company, any dividends paid, plus the money we collected for the option.
The same is true if the stock goes nowhere or down during the life of the contract. And it’s even true if the stock temporarily goes above the strike price but the investor holding our option fails to exercise it.
Also, once the contract expires we would be free to write a new call with a new strike price and a new time frame. This means we can continue collecting more and more premiums!
Meanwhile, the last possible scenario is that the stock rises above the strike price and the investor exercises the option before it expires.
In this case, we will be forced to sell our shares to the options holder AT the strike price. Please note that this is our only obligation. We can never be forced to sell the shares at any price other than the strike price!
In other words, the worst thing that can happen with covered call writing is that we will be forced to part with our shares for the predetermined strike price — which means we lose any additional upside from that point on.
But with covered call writing, we can never suffer any additional downside risk … as long as we pick strike prices that are higher than our entry prices plus commissions!
That makes covered call writing about as foolproof as a strategy can be.
Now, to actually do this in the real world, you first have to get your brokerage account authorized to write options.
The process and time involved might vary a bit based on your broker, but essentially all you should have to do is fill out a form requesting “Level 1 Options” clearance. This allows you to write covered calls, and it is even available for IRAs.
A couple final points:
First, I typically recommend writing contracts that are “out-of-the-money.” In other words, you’re looking for strike prices that are HIGHER than the underlying stock’s current one — and CERTAINLY higher than the price you paid for the shares (including actual and potential commission costs)!
This is the only way to be sure that you won’t lose money on a covered call strategy.
Second, I recommend placing limit orders when you write covered calls. In other words, you should specify the lowest premium you are willing to accept for a given contract.
Third, assuming a contract gets written, you obviously CANNOT sell the underlying shares until the contract expires or is exercised.
As long as you follow these basic rules, covered call writing is something you should seriously consider doing.
And quite frankly, it’s even better when you combine it with cash-secured put selling as we do in my Superstar Trader service.
I say that because it is entirely possible to make money targeting high-quality stocks through put sales …
More money from dividends and capital gains you might receive on any stocks that get “put” to you …
And then extra money on top of that by selling covered calls against the underlying shares!
So don’t be scared by the word “options.”
The reality is that various options writing strategies, when used correctly and combined with solid dividend stocks, can set you up for perpetual streams of income while also lowering your portfolio’s risk in the process.