Using Covered Call Writing To Wring Extra Income From Your Stock Portfolio

If you already own a portfolio of stocks, you can generate additional income by selling covered call options on those stocks. Owning a stock and simultaneously selling a call option on that stock makes this a covered transaction. A call option gives the buyer the right, not the obligation, to purchase 100 shares of a stock at the strike price and has a time duration of one, two or three months.

This strategy works best when you have neutral or bullish expectations for the stock in the long-term, but expect the stock price to remain in a narrow trading range during the time before the call option expires. The ideal situation occurs from selling the call, collecting the premium and letting the option expire unexercised. You must close out every option that you sell by either buying the option back or letting it expire worthless. The options expire on the third Friday of every month.

The Downsides Of Covered Call Writing

The strategy of covered call writing limits the upside profit potential. If the stock price moves considerably above the strike price, the call option becomes “in the money” and the holder of the option will exercise his right to purchase the stock from you. You will only gain the appreciation from your initial purchase price to the strike price plus the premium received from selling the call option and any dividends declared during the duration of the option. You give up any price gains above the strike price.

Conversely, this strategy has unlimited potential for downside loss. If the stock price goes down, the call option will expire worthless and you can keep the premium. However, the value of your stock portfolio can continue to decline. The premium received from selling the call cushions the loss somewhat, but probably not enough to offset the depreciation in stock price.

Experienced option traders sell covered call options when the options seem expensive, thus generating the highest premium. Depending on their volatility, option prices will vary between appearing cheap or expensive. An analysis of an option’s historical volatility chart will provide some indication of whether the price seems expensive or cheap.

Writing covered call options is considered to be a conservative strategy to boost the income return of a portfolio of stocks. As long as the stock price remains in a narrow or slightly up trending price range, you can continue to sell covered call options every month and receive the premiums throughout the year.  Of course, it goes without saying that covered call writing could backfire;  however, even the worst-case scenario is no worse than what you were already exposed to (that is, a total loss).