Five Success Tips to Writing a Covered Call

TradeKing reports:

"Writing covered calls works best on stocks with options that are exhibiting medium implied volatility. This means you want to use a stock that has the ability to move, but in a somewhat predictable way. If implied volatility is too low, the option premium you collect will also likely be low. If implied volatility is high, the premiums will also be higher, but there is a trade-off. The higher the implied volatility, the greater the likelihood for the stock to move significantly in either direction. This could mean you have a higher chance of having your stock called away if the price increases, or of taking a loss if the stock drops sharply. Remember: If the price rises enough that the call buyer exercises the option and calls your stock position away from you, you’ll no longer be a stockholder – precluding you from participating in future gains in the stock beyond the strike price. In other words, medium volatility should provide enough premium to make the trade worthwhile, while reducing the amount of unpredictability found with high-volatility stocks. Only you can decide what kind of option premium will make this strategy worth executing...[I]mplied volatility can only be determined using an options pricing model. While this information can be helpful in your decision making process, it’s still hypothetical. Again, implied volatility tends to indicate the likelihood of a stock fluctuating. But bear in mind, this may not turn out to be the case in the real world...If you’re called upon to deliver stock, it can come as a surprise. Some covered call writers worry about losing a long-held stock position this way. But you have more choices in this situation than you may realize...If you’d rather not let go of any of the stock you’re holding, that’s also okay. It’s possible to buy the stock on margin in the open market and deliver those shares instead. This will give you better control of the tax consequences and your long-term positions. However, take into account that if you want to deliver newly acquired shares you’ll need to anticipate your assignment and buy the shares in advance of receiving the assignment notice. Furthermore, buying stock on margin has its own risks. Margin is essentially a line of credit for purchasing stock, for which you make a minimum down payment and pay your broker an interest rate. If the market moves against you suddenly, you may be required to quickly add to this down payment in what’s termed a 'margin call'. Read up on the risks of margin to use this tool wisely...You’d typically write a covered call on a stock on which you’re bullish in the [long term]. If the stock goes south, it helps to have a plan in place. After all, nobody likes it when stocks go down. But once again, you have more choices than you think. Contrary to what many investors assume, selling a call doesn’t lock you into your position until expiration. You can always buy back the call and remove your obligation to deliver stock. If the stock has dropped since you sold the call, you may be able to buy the call back at a lower cost than the initial sale price, making a profit on the option position. The buy-back also removes your obligation to deliver stock if assigned. If you choose, you can then dump your long stock position, preventing further losses if the stock continues to drop...If you’re attracted to covered calls as an ongoing income strategy, you can buy the stock and sell the call option in a single transaction. This is called a 'buy-write'...Buy-writes offer more than convenience. For one thing, you reduce your market risk by not legging into the strategy. (When you get into a multi-leg option position in more than one transaction, that’s called 'legging' into the trade.) Because a lot can happen between one trade and the next, even if they’re just a few moments apart, legging into a position can pose some additional risks. That being said, using a multi-leg position can also be tricky. You’ll incur two commissions and it may involve complex tax treatment depending on your personal situation. Be sure to check with a tax advisor before trading a buy-write...Covered calls are a way to earn income on your long stock positions above and beyond any dividends the stock may pay. 'Static' and 'if-called' returns help you figure out if selling the call makes sense for your investment strategy. 'Static return' on a covered call refers to the scenario in which you sell a covered call and the stock doesn’t budge – allowing you, as the writer, to keep the premium as income. 'If-called return' assumes assignment does occur and you deliver the stock at the strike price. You should do the math for both of these scenarios before diving into covered call writing. These numbers are important to ensure you’re working towards your investing goals when implementing this strategy, and that you’ll be satisfied with your returns in the event of either outcome...Covered calls can be a handy strategy to generate income on your holdings above and beyond any dividends. Typically, you’ll write covered calls on stocks toward which you’re long-term bullish, but not expecting large gains in the immediate future. They can be particularly useful on stocks that are stagnant or experiencing a small dip in the short term. But be careful. As with any other option strategy, covered calls are never a sure thing. You need to understand your risks and enter the trade with a plan for all possible outcomes."