7 Tips for Successful Covered Call Writing
Writing covered calls is a strategy used by investors to ensure that they make a profit from selling their stocks at an unlikely strike price. When you write a covered call, you are selling someone the option to purchase your stocks at a specified price within a specific time frame.
If you want to succeed at covered call writing, we have 7 essential tips you should learn.
1. Know the basics of covered call writing.
Writing a covered call means you sell the option to another investor to purchase your stock at the assigned strike price within a certain time. An investor can get this option at a set premium price.
Here are a couple of things to know:
- You need to have 100 shares to be able to write a covered call.
- The strike price should be higher than the market price.
- The premium price should only be a fraction of the market price.
- You must follow through with the terms according to the agreed-upon expiration date.
For example, you have 10o QRS stocks. The market value of these stocks is $100 per stock. You can write a covered call that gives the buyer the option to purchase your stocks, with a premium of $2 per stock within 30 days.
Let's say you set the strike price at $105. If your stock rises to $105 within 30 days and the buyer decides to purchase them, you have no choice but to sell. However, if the stock remains at market value and the buyer doesn't want to purchase them, you still would have earned $2,000 as your premium income.
2. Assign an appropriate premium price.
The premium is the price someone can purchase the option to buy your stocks. Generally, investors advise setting 2% of the stock price as the right amount for the premium. Let's say the stock is priced at $100. The appropriate premium price is $2. Going above this requires research and calculated guesses. If the marketplace shows that the performance of your stocks is doing well in terms of value and demand, you can definitely increase your premium.
Always remember that this is one of the main reasons people use the covered call strategy. This is a surefire way to earn from your stocks. When you sell the option to other investors to purchase at certain stock prices, you are already earning at least 2% of the current market price of your stock.
It may not be a lot, but it's 2% more than what you had this morning. Whether your shares perform well or you need to sell stock eventually, you will have a small amount of downside protection.
Set an appetizing strike price.
When you decide to write a covered call, you need to set a strike price. When the stock rises and hits the assigned strike price, the buyer has the right to purchase your stocks at that price. Picture this: your stocks are at $100 selling price at present. You sell covered calls at a $2 premium, so the buyer can get your stocks at a $105 strike price, within 30 days of purchase.
A good covered call writer will set a desirable strike price that will seem attainable to the potential buyers of the call option. Buyers need to see that the covered calls are good deals. Based on market conditions and trends, you will most likely find the best strike price to assign.
In our example, setting $105 as the strike price is a good idea only if the market predicts stagnant performance within the assigned expiration date.
4. Use covered calls to enhance the overall return on your stock position.
Writing and selling covered calls is a great way to cover the upside risk of your stock's call options. When you don't consider writing a covered call, your stock has an endless loss potential. Selling calls is a solid investment strategy that allows you to collect the option premium, which gives you added downside risk protection.
Writing calls also reduces the cost basis of your stock. Let's say you have 100 shares of XYZ stock with the purchase price of $70 per share. Your covered call buyer can opt to buy your stock at the strike price of $85. They will purchase this premium at $2.50 per share, which totals $250. It automatically decreases your stock cost basis to $77.50 per share.
5. Take advantage of the bullish market.
Before you decide writing covered calls is the best way to maximize profits, you will need to study market volatility and trends. When you discover that your stocks are swimming in a bullish market, meaning the stock price rises constantly, you can take advantage of this.
So, if you're in a bullish market, and you decide to write a covered call, you are automatically assuming you are going to sell. This means you can increase the call premium a little more. If you would normally set the premium at 2% of the market value, you can go as far as 4-5%, depending on how the stock performs. This way, you can generate income and boost returns as much as possible.
6. Be prepared to lose the stocks bound to the covered call.
When you write a covered call, you have to accept that there is a chance you will lose these stocks. If you have shares that you're emotionally tied to, it may not be a good idea to write a call option for those.
You are also letting go of the potential profit these stocks may bring, in case they perform well in the future. Some stocks may be stagnant for long periods of time, but you will never know what can change in the market. If the stock performs better after a few months, you are also losing that opportunity for increased profit.
7. You should be willing to own the underlying stock.
So, let's say you decide to write a call option for your stock. You may have discovered that this is the best way to manage risk and maximize profit potential. You may have even seen promising trends in the market regarding the performance of the stock. The best case scenario is the stock hits the strike price, and you can sell at that value, plus the premium you got for selling the call option.
However, when the stock declines, you have to be willing to stick with it even if it crashes below breakeven point. So, make sure to invest in good quality shares that you can rely on even when the market gets unstable.
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