Writing covered calls is an income-oriented strategy with a bearish bias. Covered call writing is a form of a straddle -- a two-legged investment in which each of the legs hedges the other. The call writer already owns the underlying stock and sells the call to extract a little income from the stock. Some stocks fit more naturally into a covered call strategy than do others.
A call gives the buyer the right to purchase 100 shares of the underlying stock at a set price -- the strike price -- on or before the expiration date. The call writer receives a premium -- that’s the income part -- but is on the hook to sell the 100 shares at the strike price if a buyer exercises the right to purchase. With covered calls, the writer already owns the required shares. If the writer paid less than the strike price for the shares, she will profit by the difference if the Options Clearing Corporation calls the shares.
What a Covered Call Writer Wants
The covered call writer usually sells short-maturity options that are out of the money, meaning the current stock price is below the call strike price and the option expires in less than two months. The stock price would have to rise above the strike price for a call to occur. Normally, the call writer wants to hang onto her shares so she can continue to write calls against it month after month, collecting her premium each time. Her ideal stock snoozes around at its current price, too sleepy to move in either direction. Since she owns the stock, she doesn’t root for its price to decline, just to hang steady below the call’s strike price until expiration.
Besides sleepy stocks, dividend-paying stocks are good stocks for call writing. Dividends and stock repurchases are two ways a company’s board of directors can use up extra cash. A high dividend helps the call writer in three ways. The amount of the dividend reduces the stock price, creating more distance from the strike price.This works best if you sell the call at least one month before expiration, or else you might face a lower premium. Secondly, the call writer pockets the dividend, because she owns the stock. Third, high dividend companies are often bloated corporate behemoths that turn in steady, unspectacular performances each year, a perfect recipe for a stock price that snores rather than soars. The call writer doesn’t want a share buyback program, as these tend to raise stock prices.
Other Good Features
A hibernating stock with a high, steady dividend is a good start for writing calls. You can refine your choices by looking for stocks in boring industries: Electrical utilities, pet food producers, waste disposal firms and undertakers spring to mind. Look at the price history of the stock. You’d like to see a horizontal line stretching off into the murky past. The company should have an average growth rate and not be subject to takeover rumors. There should be no shortage of the stock that would drive up prices. In short, you want a yawner: slow and steady, too big to grow and too old to adopt new ideas. With luck, you can write calls every quarter around six weeks before dividend time on a warren of these Rip Van Winkles and collect income all year long.
- Internal Revenue Service: Publication 550 -- Investment Income and Expenses (Including Capital Gains and Losses)
- Option Industry Council: Covered Call (aka Covered Write, Buy/Write)
- Seeking Alpha: 11 Dividend Stocks for Covered Call Writing
- Seeking Alpha: Covered Calls on Dividend Stocks -- Enhancing Returns or Kidding Yourself?
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.