5 Tips for Covered Call Traders - Tip #1

Pick a Stock You Believe Will go Up!

Many traders view covered calls as a means of generating a never-ending stream of income earned by selling options against a particular stock that never moves. The problem with that is that the options on stocks that don’t move much tend to be cheap – meaning you can’t earn much from selling those particular options.

And believe it or not, many traders actually want the stock they select to go down! This way they can earn income as the call options they sell expire worthless. That logic is a bit off-kilter considering that the income earned from selling the option can easily be offset by a decline in the stock price.

Remember, The best-case scenario in a covered call trade is for the stock to go up significantly, forcing you to sell and lock in a profit. The second-best scenario, is that the stock goes up but the option still expires worthless. Here’s the mathematical breakdown, with commission expenses excluded for the sake of simplicity:

On Monday October 20^th, I made the following trade:

• Bought RJF at $24.20
• Shorted November $25 call against it for $1.80

This gives me a cost basis of $22.40 per share. Now let’s assume the stock finishes at $25.50 at expiration on November 21. I am forced to sell my stock at $25 (the strike price of the option) a share, giving me a profit of $2.60 a share ($25 + $1.80 - $24.20) or 11%.

But what if finishes below $25 on November 21? Say, $24.75, I’m happy because the call option I sold expires worthless, and I’ve made a total profit of $2.35 a share. And more importantly, I can sell another option against my stock and increase my total profits.

However, keep in mind that in the first scenario, I have a realized gain that nobody can take away. I’m free to spend it on a toaster, new golf clubs, or some barbecue ribs. In the second scenario, I am still long the stock which has the potential to go down and offset any prior gains I made.

So if you’re trading covered calls – do yourself a favor and pick a stock you think will go up, rather than one whose options can just provide you with income.

The Rest of the "5 Tips for Covered Call Traders" Series

Tip #2 - Shoot for the Clouds, Not the Stars
Tip #3 - Stick With Short Durations
Tip #4 - Watch Those Commissions!

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