Covered Call Writing - An Income-generating Strategy

Essentially this is an income-generating strategy. For the novice, the analogy is that of receiving an extra dividend each contract period. In Australia, the majority of the well-known blue-chip Australian stocks have monthly or three-monthly contract periods. When purchasing a stock with the intent of writing covered calls as soon as the investor/trader has the buy is confirmed is known as a 'buy-write'.

Covered Calls are generally considered as a conservative income generating strategy because the potential loss is limited. Covered Call writing involves a call option being sold (or 'written') against a holding of the underlying shares.

Writing covered calls gives another party the right to buy the stock at the option strike price. When writing covered calls, the investor/trader is selling the upside potential of a stock to speculators. Since their focus is on monthly income and not long-term capital gain when writing covered calls, it is advantageous if the stock price goes up and the stock gets called away.

When writing Covered calls the investor/trader must be prepared to do one of the following:

1. Allow the stock to be sold (assigned or called) at the option strike price at anytime before the covered calls expire
2. Buy the covered calls back on the open market before they are exercised.
3. Let the covered calls expire unexercised (on the third Friday of the month)

Writing Covered Calls - The basic steps

• Have your broker buy the stock you've selected for covered calls in marketable parcels of usually 1,000 shares. (Check with your broker as some stocks require more)
  
• Then have the broker sell the covered calls. If you don't want the stock to be called, you could roll up or roll forward, or roll the covered calls up and forward. You could keep writing covered calls and collecting option premiums each month until the stock is called.
  

This is a good strategy if you have the view that the stock has had a good run and looks likely to plateau for a period of time. In today?s market, think of stocks like the banks. They have enjoyed a strong upward momentum over the past few months and seem likely to trade within a band range in the coming months. Writing the call at the top of this range will provide maximum premiums, whilst lowering the probability of your stocks being called away; allowing you to write once again after the contract expires.

The Downside:

If the stock pushes up well past the strike price, the investor/trader will not gain the benefit of the capital gain as the stock is called away at the strike price the call is written at. Additionally, selling stock at ad hoc times has tax implications that may not be beneficial to the investor/trader. Please click here for more traps to consider when writing covered calls.

In theory, if the investor/trader believes the share price has reached a temporary peak, selling covered calls gives them some protection against a pullback in the share price. The premium received compensates for the temporary fall in the price of the share.

For a practical example of covered call writing follow this link