Covered Call Writing - Basics

One of the conservative ways to write options is to do covered call writing. This is a way to generate additional income for your stock portfolio. Covered call writing refers to writing calls against the stocks that you own.

Here, there is no risk from writing the call. The obligation of writing the call is offset by owning the stock. For example, if you own 100 shares of Pfizer priced at 40 and write the Pfizer Jan 45 call at 2, you receive $200 to your account but are obligated if Pfizer is above 45 and you are exercised to deliver the stock at 45.

Covered call writing is ideal when you have a target where you wish to sell the stock. Then you are getting paid as you wait for the stock to hit your target. In our Pfizer example, if your target for Pfizer was 45, you receive $200 as you wait for the stock to exceed 45. If the stock does not get to 45, you can write an-other option with a strike price of 45 and collect more premium as you wait. If the stock is called away at 45, you receive 45+2 or $47 a share.

When you don’t want to sell the stock, follow the guidelines that we presented in the previous chapters. Only write an out-of-the- money option with a high probability of expiring, set a stop-loss and buy back the option if the stop is hit. Then you can roll into a new option writing position, further out-of-the-money if you desire.

Your danger here is that the stock could gap up over the strike price, and you could take a bath buying back those options. Always close out all positions when most of the premium vanishes. Avoid covered call writing on a stock in a strong up-trend unless you believe it is making a top, and then it may be wiser to sell the stock than to write calls on the stock.