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Selling covered calls is an income-generating strategy that you can use to increase your returns on stock holdings. It’s also a strategy to use to buffer your losses if you believe the market will have a slight pullback in the near future. Some investors use them in tandem with dividend payouts to generate income during retirement, although you could incur losses during a market decline. If you’re willing to bear the risks involved, covered calls could be well worth your time to research.
Knowing the strategy is only a part of the execution. To maximize using covered calls, you should select stocks you believe will not experience highly volatile movements during the term of your options contract. Let’s go through a few good candidates that you might be able to use in a stable to rising market.
Overview: Covered Calls and Stocks
Selling a covered call means writing a call option against shares of a stock that you own. This combination has the same risk profile as selling a naked put option, and so it exposes you to virtually unlimited downside risk while having only limited upside potential up to the strike price. If you sell a call option, that call loses value if the stock price declines or the market stays relatively stable while time passes.
With the covered call strategy, if the stock price rises, the gain in the value of your shares completely covers the losses from your call option beyond the option’s strike price. At expiration, you will show a net gain if the stock’s price has risen up to or beyond your sold option’s strike price, although you’ll need to either give up your stock or close out the option if the option ends up in-the-money at expiration. Furthermore, if your stock falls in value by more than the premium you sold the call for, you stand to lose money just as if you had sold a naked put option.
Covered call writing can also lower your cost basis for buying stock. If you own $13,000 worth of Walmart split among 100 shares, your cost basis is $130. If you sell a covered call option on 100 shares against those shares for $115, your cost basis drops by $1.15 per share. It is as if you bought the shares at $128.85 instead of $130, although your profit potential is eliminated if the market rises above the strike price at expiration.
Although this combined position has unlimited downside risk, it could present an attractive proposition if you tailor your portfolios for income rather than growth. It’s also a good consideration if you expect a relatively stable to slightly rising market in a stock over a particular time frame.
Best Online Brokers for Covered Calls
The best stock candidates for writing covered calls on are usually big, stable, blue chip companies listed on the major stock exchanges. These choices are usually available from reputable brokers that offer stock options trading to their clients. Take a look at these market leaders and compare their feature sets to ensure the closest match to your needs and preferences.
Features to Look for in Covered Call Stock Plays
- Sideways market activity: Options are contracts that can lose their time value as they get closer to expiration, although their time value also depends on other factors like volatility levels and the proximity of the option’s strike price to the prevailing market. If you’re selling a covered call against stock you own, you typically profit as time moves on given a stable stock price.
- Uneventful stock: The less a stock is featured in news events, the less likely it will be affected by the resulting drastic price changes as market participants engage in emotional buys and sells.
- A clear and unremarkable schedule: You can’t avoid unexpected shocks to a stock or a market, but you can look ahead and choose stocks with issuing companies that are not planning anything that could potentially create volatile trading conditions. Risk events you would probably want to avoid include product trials, mergers and acquisitions, earnings announcements and leadership changes.
Dividend investors who don’t take a look at selling covered calls may be missing out on some extra income in relatively stable and predictable markets. There is a risk of holding stock in your portfolio, and you can adjust that risk by selling covered calls. Selling covered calls is a strategic way to earn income to cap your profits while also buffering the risk of virtually unlimited losses in case your stock’s price falls.
In general, stocks under $10 and stocks under $5 are usually not good candidates for the covered call strategy. Stick to large-cap blue chips instead due to their greater liquidity that tends to result in more orderly markets. If you need more help with market strategies, consider checking out the Benzinga options newsletter. Bookmark this site for more up-to-date information on covered calls and other strategies that can help you pull the most out of the market.
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