Four Criteria For Picking the Best Stocks For Covered Call Writing

Covered call writing is a popular option strategy that many individual traders and investors use to generate income. It’s popular for two reasons: it’s an easy strategy to understand and trade, and it can be set up relatively conservatively.

For those unfamiliar with the covered call writing strategy, it works like this: for every 100 shares of an optionable stock that you own (each option contract represents 100 shares of the underlying stock, although not every stock trades options) you can sell someone else the right (but not the obligation) to buy those shares from you at a certain price (strike price) by a certain date (expiration date). The amount you receive for writing the call is called premium, and it’s immediately added to your brokerage cash balance as soon as the trade is processed.

If the stock closes above the strike price at expiration, you will be obligated to sell your shares at the agreed upon price. If not, the call option expires worthless, you retain ownership of your stock, and you are free to repeat the process.

Although covered call writing is a fairly straightforward option income strategy, that doesn’t mean it’s easy to consistently make great returns. The strategy has two significant risks:

When the underlying stock makes a large move down, the premium income you receive acts as a limited buffer only – it will protect you to a certain extent but not if the stock really crashes
When the underlying stock makes a big move up, you’ll miss out on any capital gains above your strike price (the price at which you agreed to sell your shares)

That’s why proper trade selection is so crucial to successful covered call writing. Arbitrarily choosing stocks on which to write covered calls, or worse, choosing stocks primarily because they have high levels of premium (the higher the premium available, the greater the expected volatility of the stock), are recipes for covered call failure.

Here then are four criteria for picking the best stocks on which to write covered calls:

Choose stocks with good fundamentals. If you write covered calls solely for the income, you should still select stocks that you think would actually make attractive long term investments. Depending on how you set up the trade, you can still profit if a stock trades lower, but a strong, reliable, and profitable company tends to make fewer, less shallow, and shorter in duration share price dives. Remember, you must own a stock first before you can write covered calls on it. So choosing mediocre and unprofitable companies only adds extra risk–and stress–to the trade.
Choose stocks with good technicals. There is no requirement that you become a technical analysis superstar in order to be successful at covered call writing, but you should at least familiarize yourself with the basics of technical analysis. I’m not a big technical oriented trader myself, but if you’re going to be making short term option trades (even if they’re conservative covered call trades) you really do need to have some kind of basic understanding of technical analysis or access to tools and resources that can help you quickly assess the short to intermediate term technical health–and therefore the covered call suitability–of a stock.
Choose stocks with solid growth prospects. Stock options associated with growth stocks typically have more premium available than mature or extremely predictable companies. That’s because they’re historically more volatile, as the level of growth (or the point when growth begins to slow) can be difficult to forecast accurately. In order to generate significant income with covered calls, you will need to focus on growth stocks. Not all growth stocks are created equal, however, and you’ll do yourself a huge favor by taking a little extra time to use various research tools and resources to help you separate the the wheat from the chaff.
Choose stocks with attractive AND realistic premiums. If you’re writing covered calls for income, you’ll want to choose stocks (technically and fundamentally healthy and with solid, long term growth prospects) with an attractive enough amount of premium in order for it to be worth your while. But you’ll also want to be realistic. When you come across options with an explosive amount of premium available, beware. High levels of premium equals high levels of expected volatility and uncertainty. No matter how high your potential returns on the trade, these type of stocks are not suitable for consistently successful covered call strategies.

Writing covered calls can be a great strategy to generate significant streams of income. But just because it’s an easy strategy to understand and to trade, doesn’t mean it’s an easy strategy to successfully execute on a consistent basis. The good news is that there are numerous resources available to improve your covered call performance and returns.

For additional covered call income information and resources, please visit http://www.great-option-trading-strategies.com/covered-call-options.html

About The Author:

Brad Castro is a practitioner and promoter of Leveraged Investing, or option trading techniques and strategies designed to simulate successful value investing. Leveraged Investing has two objectives: to acquire stock in quality companies as cheaply as possible and then to squeeze more returns from those stocks once they’ve been acquired. Please visit http://www.great-option-trading-strategies.com for more information.

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Tags: options, stocks, trading

Wednesday, October 5th, 2011 Education, Options

1 Comment to Four Criteria For Picking the Best Stocks For Covered Call Writing

I plan to use Covered Call Strategies for all Market Conditions to boost income in my trading account. If I can fine tune the process I will move it to my retirement accounts.