A Refresher: Profiting with Covered Call Writing

Markets appear to be stalling at the chart tops and, based on a lack of catalyst, could be heading lower. Yes, there was the breakout at the chart tops and a bullish head and shoulder formation, but the lack of stronger volume on the rallies and higher moves makes it less of a validation for the breakout. Watch to see if markets can hold at the chart tops, otherwise we could see a retrenchment back to the 200-day moving average.

The advance in the market is wonderful, so enjoy it. Yet, at some point, given the technically overbought condition, I expect there will be some profit-taking emerging. It doesn’t take a market guru to reason that markets cannot go up indefinitely without some type of market adjustment. Just take a look at any price chart over an extended period of time and this becomes apparent.

As an investor, what you can do when you feel the market may be set to take a pause and stall is to write some covered calls on your long positions. I have discussed this on numerous occasions in the past, but I feel the need to remind traders and investors about this simple strategy.

Covered call writing (also called Buy-Write) means you hold an underlying position in the stock represented by the call option and is much less risky compared to naked call writing, in which you do not have an underlying position in the stock. Be aware of this distinction, since it will save you lots of stress and potential unnecessary losses in the long-run.

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Let’s take a look at Cisco Systems, Inc. (NASDAQ/CSCO), and assume you own 1,000 shares at a cost base of $18.00 per share. You are already up $3.55 a share based on a share price of $21.55 on Wednesday. You continue to be bullish on Cisco longer-term, but at the same time feel that the near term may see limited gains.

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, a generator of premium income, and 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 mid-term neutral on Cisco and believe the stock may have limited upside potential prior to January 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 OTM Cisco January $22.50 call option contracts (OTM since strike price is greater than market price) at $105.00 per contract, or $1,050 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 want 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 $22.50. If this were to happen, you would make $4.50 on the stock, plus $1.05 for the premium, for a return of $5.55 on the base cost of $18.00. The return would be 31%. The downside of course is that you lose the stock, especially if it advances higher above $22.50.

Each situation is different, so be careful when doing covered call writing.