A Strategy You May Want to Use in the Weeks or Months Ahead

covered call writingMarkets are continuing to edge higher after breaking above the previous chart tops, which is technically bullish. The DOW is 0.67% below its chart top, but I suspect this will be broken.

The break above the previous chart high may be sustainable, but failure to hold could leave stocks vulnerable to downside weakness.

As an investor and trader, 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.

This could be the case in the weeks or months ahead.

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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, as it will save you lots of stress and potential unnecessary losses in the long run.

Let’s take a look at Cisco Systems, Inc. (NASDAQ/CSCO). Assume you hold 1,000 shares at a cost base of $15.00 per share. You are already up just over $4.50 a share based on the prevailing price of $19.64.

You continue to be bullish on Cisco, but at the same time feel that the stock may pause given its failure to move higher, retrenching back towards its 52-week low of $19.00. 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 straightforward, low risk; a generator of premium income, as well as guaranteeing a selling price for the stock. Don’t write a covered call if you do not wish to chance losing 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 April 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 April $22.00 Call option contracts (OTM since the strike price is greater than market price) at $44.00 per contract, or $440.00 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 should 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 $22.00. If this happens, you would make $7.00 on the stock plus $0.44 for the premium, for a return of $7.441 on the base cost of $15.00. The return would be about 50%. The downside of course is that you lose the stock, especially if it advances higher above $22.00.

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