How to Put This Popular Income Strategy Into Action

Many traders are familiar with the “covered call” option strategy.

You can write call options on a stock you own to generate extra income.

Yet when you’re starting out, you might not be sure when to use a covered call strategy.

So today, I want to look at some factors to consider when putting this strategy into action…

A “Neutral” Strategy

With options, you always need to understand your obligations. And this strategy is no exception.

If the buyer exercises your call option, you’re required to hand over your shares at the option’s strike price.

For example, say you own 100 shares of a stock and sell a call option with a $50 strike price.

If the stock is trading at $55 before expiration, the person who bought your option will exercise it. Then you’ll have to sell them your shares for $50 a share.

So you should only write your option at a strike price that you’re willing to sell your shares.

But what seems like a good price today could change quickly if the stock rallies. That’s why you only use a covered call if you’re neutral on a stock.

Put simply, if you’re bullish on the stock, then leave this strategy alone.

It’s a similar story if you’re bearish. Collecting call option premium might cushion some of your losses. But it’s not going to cover all of those losses if a stock falls heavily.

In that situation, you’d sell your shares directly or protect them by buying a put option. (In either case, consider any tax implications. And decide what best suits your financial needs and goals.)

When to Write a Covered Call

Ideally, the best time to sell a covered call is when a stock is trading in a sideways range. You can see that with Hershey (HSY) in the chart below.

(Please note that this example isn’t a recommendation.)

After bottoming out last December, HSY transitioned into a sideways trend.

In this example, you believe that HSY is going to remain trading in this range. So you might write your option at around $200 (red line).

There’s a key thing to remember here…

The closer you write your call option to the current stock price, the more premium you’ll receive.

But this also increases the likelihood that the buyer will exercise your option.

Let’s say you wrote this option in mid-April.

The $180 stock price was well below the $200 strike price. That could have generated around $2.00 per share (or $200 per contract) on an option with around 45 days until expiry.

But if you write this option today, the strike price is closer to the stock price. So you could generate around $4.50 per share (or $450 per contract) on an option with the same time horizon.

Remember, you want the stock to close beneath the strike price at expiration. Then you get to keep this premium and your shares.

That’s the ideal income scenario.

Do this repeatedly over six months or longer, and those premiums will really start to add up.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict