Today’s Trading Lesson From TradingMarkets

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Writing Covered Calls

By Len Yates

Many traders
use covered writing to enhance the returns from their long stock
portfolios. A covered write is the sale of a call option “against,” or “covered
by” a long position in the underlying security. When you sell calls against your
stocks, you are giving someone the option of buying your stock from you any time
during the life of the option for a stated price–the strike price–of the
option. In return for giving up all possible gains above the strike price you
receive cash for the options you sold.

Option sellers are said to be
“writing” options because they, conceptually, originate the contract(s)–not
that anybody ever sees actual paper contracts.

In times when stocks move in a
sideways, slightly downward pattern, covered writers benefit greatly from the
additional income generated by the sale of call options.

When someone tells me they don’t trade
options because options are too risky, I usually cite the covered write as an
example of using options to reduce risk.  And it’s true.  The sale of covered
calls reduces the risk of a stock portfolio in the sense that returns are not as
variable.  In theoretical terms, you have reduced your portfolio’s variance. 
And returns are enhanced if stock prices remain the same or fall.

However, your calls do nothing to
protect you against losses as the market falls.  This is the only “knock” on
covered writing–that it takes away your upside and leaves you with the same
downside risk as a regular stockholder.

That’s true in theory, but we have
clients who manage to keep some of their upside potential through careful
management of their positions.  How?  By rolling.  After a stock moves up, they
re-purchase the short calls (at a loss) and sell new calls at a higher strike. 
This allows them to stay in an uptrending stock so that capital gains from the
sale of the stock are deferred.  Note that losses from re-purchasing the short
options can be claimed immediately.

The other smart thing these clients do
is sell when options are expensive.  Option prices fluctuate between periods
when they are cheap or dear.  If you focus on selling when options are
expensive, it can make a big difference!  Options-trading software can help you
know when a stock’s options are cheap or dear on a historical basis.  Or, refer
to the

Most Overpriced Calls page on this site for currently overpriced calls.

At the time of this writing, Home
Depot’s (HD)
options were expensive.  An analysis shows some excellent potential returns from
selling just out-of-the-money calls.

Next time we’ll discuss a variation on
the covered write strategy, called a covered combo, that gives the investor true
downside protection.