Seven Suggestions for Writing Covered Calls

Looking to add some extra cash to your portfolio? Many investors use covered calls to do just that. The only problem is most people have heard it’s a great way to make some extra money on their stock holdings, but many of them aren’t aware of the risks involved.

The following article by Michael Thomsett lays out the risks involved in writing covered calls, and he suggests a few ways to reduce those risks.

The big appeal of covered calls has always been the double-digit annualized return that is not only possible but likely. Gains come from three sources: capital gains on stock sales, dividends, and option premium.

But is it always profitable? No; you can lose money writing covered calls and even experienced options traders can easily overlook this issue. If the stock price rises well above strike, your stock gets called away below market value, so you would have made more profit just owning the stock. However, this does not happen often enough to offset the amazing gains you are going to earn most of the time.

The larger threat is what happens when stock prices fall. The breakeven is your original basis, minus the amount you get for selling the call. For example on March 30, 2012, Exxon Mobil (XOM) closed at $86.73 per share. If you previously paid $84 per share for 100 shares of XOM and on March 30, sold a July 87.50 call for 2.31 ($231) your net basis would be $81.69 ($84.00 – $2.31). So is this risk associated specifically with covered calls? It is not. If you just own the stock, your basis is still $84, so covered call writing reduces your market risk.

It makes sense to structure your covered call properly to ensure that you maximize gains while reducing risks. Some suggestions:

1. Remember that exercise is a possibility. Don’t write covered calls unless you are willing to get exercised. This can happen any time the call is in the money, and you have to be willing to accept that. The most likely day of exercise is the last trading day, but it can also happen on or right before ex-dividend date … or any time for that matter.

2. Pick a strike with your basis in mind. It makes no sense to write calls at a strike below your basis. In the event of exercise, this will mean you end up with a net loss on the stock. Always pick a strike that will result in a net gain. In the XOM example, the 87.50 call was not only well above the basis of $84; it was also out of the money based on the March 30 closing price.

3. Go for shorter expiration, not longer. When you review the dollar value of different options, you realize that further-out expirations get more money. Even so, you are going to make more return picking expirations within two months or less, even though the dollar value is lower.

This is better for two reasons. First, it means having your capital tied up for less time. Second and more important, your annualized return is going to be higher because time decay as accelerated during the last two months. So you are generating more profits with six 2-month expirations than you would with one 12-month.

4. Go to for the other four suggestions

Option Trading Secrets