Sell Covered Calls to Benefit from
Market Pause

How to generate some premium income and reduce the average cost base of your positions with covered call writing.The lack of any catalyst, along with nervousness regarding the banks, is helping to exert continued downward pressure on stocks. The seven-week winning streak by the S&P 500 is at risk. And, without leadership, markets may stall. Should this happen, write some covered calls to generate some premium income and reduce the average cost base of your positions. Be careful, as a market surge could take out your position at the strike price. Make sure you are comfortable with the strike price of your covered call.

I favor the practice of writing some covered call options on some of your long positions should the market continue to be flat.

Why let your positions sit idle? Write some covered calls to generate some premium income and help reduce your average cost base. It is simple to initiate. Just make sure you do not write a naked call, otherwise you’d be exposed to unnecessary risk.

Let’s take a look at Cisco Systems, Inc. (NASDAQ/CSCO) and assume you own 1,000 shares at a cost base of $15.00 per share. You are already up $5.76 a share based on the prevailing $20.76.

Now say you continue to be positive on Cisco, but at the same time feel the stock may pause like the broader market.

There are several strategies at your disposal. You can sit on the position and wait for the stock to rise. The problem is that this is an inefficient use of capital in my view.

So, why not make your capital work for you? It’s much easier than you think and represents a win-win situation. The process involves writing covered calls on your holding of 1,000 shares of Cisco. For every board lot (100 shares) of Cisco, for example, one call option may be written.

Covered call writing is a straightforward, low-risk generator of premium income that guarantees a selling price for the stock. Don’t write a covered call if you do not wish to lose the stock due to a possible exercise from the call holder.

Let’s say you are short-term neutral on Cisco and believe the stock may have limited upside potential prior to July 2011. What’s the next step?

Given this, you could generate some premium income by writing calls on your 1,000 shares of Cisco. By writing the calls, you in turn are obligated legally to deliver your 1,000 shares of Cisco at the predetermined strike price if exercised and if assigned to you.

Here are the mechanics. You own 1,000 shares of Cisco and decide to write 10 out-of-the-money (OTM) Cisco July $23.00 Call option contracts (OTM since the strike price is greater than the market price) at $63.00 per contract, or $630.00 for the 10 contracts. This is the risk premium you get for assuming the risk and is yours to keep whether the call options are exercised or not.

The strike price selected in call writing should be what you would feel comfortable selling the stock at if it were to be exercised. If the strike price was set too low, it would have a higher probability of being exercised and you would lose your shares, perhaps at a lower price than you would want. Be careful about this. Conversely, setting a lower strike price translates into higher premiums for you. The decision ultimately depends on your view of the market.

The bottom line is that you need to be comfortable selling your shares, which in this case is at the strike of $23.00. Say this happens; you would make $8.00 on the stock, plus $0.63 for the premium, for a return of $8.63 on the base cost of $15.00 for a return of 57.53%. The downside, of course, is that you lose the stock, especially if it advances higher above $23.00. This is a valid risk, as you do not want to be taken out early and miss out of any potential upside gains. You could always set the strike price higher.

Each situation is different, so be careful when doing covered call writing. Look for stocks that look to be trading at a tight range and set the strike just above the resistance level.