A covered call occurs when a seller offers buyers a call option on a security owned by the seller at a fixed price and expiration date.
To increase investment income, professional market participants write covered calls. Individual investors can benefit from the conservative but effective covered call option strategy if they understand how it works and when to employ it.
Continue reading to learn more about covered calls and how they can help you earn more money, reduce portfolio risk, and boost your investment returns.
What is a covered call?
Covered calls can include shares in the underlying stock and call options for that stock. The call option can be sold without losing the shares when performing covered calls.
A covered call allows a person to purchase the stock at a predetermined price and a predetermined duration with premiums paid to the buyer. Many investors opt out because they are paying premiums.
Many stock advisor service providers recommend the highest quality stock for customers and subscribers. The scenario is possible when covered call maturity: The current prices for shares are below strike value.
At the time of maturity of the covered call, there are two possible situations:
The price of the stock is less than the strike price
The option expires and there is no further action
The price of the stock is higher than the strike price
The option is executed, and you automatically sell your shares at the strike price
Whatever the situation, the seller of the call option has already received the premium upfront. Hence the buyer accepts this risk when buying the covered call. By using the stock signals, you can avoid hours of technical analysis to understand the market.
To take maximum benefit out of the call option, the best time to buy a covered call option is:
When the stock price has risen to your target value
When a huge jump in price is expected following a big company news
How to Find the Best Stocks for Covered Calls
Covered calls are an excellent way to supplement your portfolio’s income. However, while the strategy is relatively simple, questions quickly arise when beginners begin to implement it. “How do you choose the best stocks for covered calls?” is usually the first question. Of course, the answer is ultimately determined by your objectives and market sentiment.
Let’s look at how to find the best stocks for covered calls, as well as some of the best tools to make the process go more smoothly.
For Long Investors
Covered calls are commonly used by long-term investors to generate income from their existing portfolio holdings. For example, in a long-term portfolio, you could own AAPL and write covered calls to increase its yield. The goal is not to generate as much income as possible, but rather to generate a little extra income above and beyond the dividend yield on the stock.
If you fall into this category, the best-covered call stocks are simply those that you want to own. When you sell a call option, you give up any potential profit above the strike price, but you keep the premium income. Also, if the stock falls, the premium income will offset some of your losses, though long-term investors aren’t usually concerned with short-term losses.
Even if you intend to keep the stock forever, you should be wary of upcoming dividends and earnings dates when writing a call option. Earnings, in particular, tend to cause higher levels of volatility. So, if the call option goes into the money, you may have to either buy it back or give up the stock (potentially triggering taxes).
For Income Investors
Some traders employ buy-write strategies solely for profit. In other words, they choose the long stock based on the potential earnings from writing the call option. When selecting stocks and options for these strategies, much more due diligence is required. Fortunately, there are a few different strategies you can employ to improve your chances.
A common strategy is to compare implied volatility (IV), which serves as a proxy for market sentiment, to historical realized volatility (HV). Covered calls should be profitable when IV generally outpaces HV over a given term. Of course, you must account for earnings, dividends, and other factors that may distort the figures.
Many traders consider downside protection and if-called return as well. If the call option holder calls the stock, you will receive the if-called return. Meanwhile, downside protection is the extent to which the option premium compensates for underlying stock losses. Both of these metrics can assist you in evaluating risk-reward trade-offs.
Screening for Opportunities
Option screeners make it simple to identify the best stocks for covered calls. Screeners generate a list of stocks that meet specific criteria and allow you to sort the list to find the best opportunities rather than going through individual stocks. There are numerous option screeners available, some of which include a free tier or free trial.
optionDash is a top option screener designed specifically for covered calls and buy-write strategies. You can quickly screen for opportunities using criteria such as market capitalization and proprietary quality scores. The stocks can then be sorted by if-called returns, downside protection, or other criteria.
5 Criteria for Successful Call Writing Stock Selection
1) Quality Companies
Choose high-quality companies when looking for the best stocks for covered calls.
I admit that I’m a bit of a broken record about this one, especially when it comes to long-term investing, but the quality stock selection is also critical when it comes to trading covered calls.
It’s so easy to be tempted by juicy premiums on less-than-ideal companies, but if the premium is the only criterion you consider, it won’t be long before you get burned. Covered calls do provide some downside protection, but if the bottom drops out of stock, you’re going to realize just how paltry that protection was.
True, when you sell calls for income, stock ownership is temporary and incidental. But even though you’re not a long-term investor, ownership is still ownership. And in the short term, even temporary ownership of a mediocre company at just the wrong time can lead to some serious pain.
The adage of writing covered calls only on stocks you don’t mind owning has a lot of merit to it. If the underlying stock makes a significant move to the downside, you always have the choice of trying some form of rolling out as you wait for the stock to come back. All else being equal, the higher the quality of the company, the more credible that choice becomes.
2) Technical Analysis and Covered Calls
Technical analysis is probably as much art as it is science, but it’s still a critical tool in the search for the best stocks for covered calls. When considering a stock to write calls on, use your favorite stock charting software and consider various short, intermediate, and longer-term time frames.
Are you able to see identifiable areas of support and resistance? The easier the chart is to read, the more predictable the stock’s price movements are likely to be in the future.
In contrast, a stock is probably not suitable for covered call writing if the share price is erratic, if it frequently violates major moving averages like the 50-day and the 200-day, or if support and resistance are either unclear or inconsistent.
You can also check out this related article on when the best time to write covered calls is.
3) Volatility, Premium, and the Best Stocks for Covered Calls
Related to the previous points about technical analysis, the best stocks for covered calls will have enough implied volatility to provide attractive premiums without being so volatile that the future share price is essentially unpredictable.
For long-term investors in high-quality companies, volatility is not a risk. For traders (including call writers), volatility is both risk and opportunity.
But it’s a fine line. As a net option seller, you get paid to assume someone else’s risk. For covered call writers, the risk you assume is stock ownership on someone else’s behalf while they retain most, if not all, of the short-term potential price appreciation
Just be sure that you don’t assume too much risk to reach your option income targets.
It’s important that the options market on any given stock you’re considering as a covered call candidate be sufficiently liquid.
If the options are too illiquid (i.e. very few contracts are traded), your trades will suffer. Not only will the bid-ask spread be too wide for good pricing (whether you’re selling a call or buying it back) but if you ever need to adjust or roll a position, the limited number of strike prices and expiration months available will constrict your choices.
5) No or Minimum Dividends
Dividends don’t get mentioned much when it comes to covered call writing, except in discussions about whether a call might be exercised early. But you should be aware that dividends do play a role in call option pricing.
In theory, on the day a company pays a dividend, the stock should trade lower by the amount of the dividend because that money is no longer owned or controlled by the company.
For example, let’s say that the XYZ Zipper Company paid a $0.50/share dividend on June 1. All else being equal, on June 1st, the company’s overall worth should decrease by $0.50/share since that’s the amount that just walked out the door.
It’s the supply and demand of buyers and sellers that ultimately determine the share price, but that dividend payout is still a short-term headwind against the stock.
The higher the dividend payout, the more of a drag that dividend will be on the premium income you’ll receive selling calls. Your best bet for finding the best stocks for covered calls is to limit your selection to those stocks that pay zero or small dividends, or else make sure you time the dividend cycle so that you have no short call positions at distribution.
How to Sell a Covered Call
You can sell a covered call in one of two ways. Either way, establishing a covered call position requires a round lot, or quantity of 100, of stock and a short call against each round lot.
The best time to sell a covered call is when a stock you own is both overvalued for the next year’s earnings and overbought.
You can sell a covered call position in any account type or trading level, including cash accounts, as long as you own at least +100 long shares of stock.
What are the pros and cons of a covered call?
A covered call can be an attractive options strategy for a variety of reasons, but like all options strategies, it has its downsides, too.
Advantages of a covered call
- Generates income from a position. A covered call can generate income from a stock position that may or may not pay a dividend, increasing its overall profitability.
- Relatively low risk. A covered call is a relatively low-risk way to trade options since you protect the short call with your stock position.
- Easy to set up. A covered call is also a relatively easy position to establish. It’s important to first buy the stock and only then sell the call.
- Hedges your risk. A covered call hedges your risk in a position by providing some compensation.
- Can be re-established over and over. If the call expires worthless and you retain your shares, you can set up the covered call again and again. Even if your shares are called from you, you can repurchase the stock and set up a covered call again.
Disadvantages of a covered call
- Small, limited upside in exchange for the downside. With a covered call, you can earn a relatively small amount of income but must bear any downside from the stock, leading to a potentially lopsided risk-return setup.
- Trading away all the stock’s upside. One of the reasons you likely own the stock is for its potential to rise over time. By setting up a covered call, you’re trading this upside until the option’s expiration. If the stock rises, you lose a gain that you could have earned.
- May “lock up” your stock until option expiration. By selling a call option, you may feel disinclined to sell your stock until the option expires, though you could repurchase the call option and then sell the stock.
- Requires more capital to set up. With a covered call, you’ll need money to buy stock and that requires substantially more cash than you’d need in a pure options strategy.
- May create taxable income. Selling a successful covered call will generate taxable income in a taxable account. In addition, if the underlying stock is called from you, it may create a further tax liability if you had a capital gain on the stock.
Top 9 Best stocks for covered calls
Using a covered call trade strategy during a bull market will underperform stocks but they will still realize profits. Below we have compiled a list of the best stocks for covered call strategy which can yield good premiums/profits.
1) Oracle (XNYS: ORCL)
Oracle is an e-commerce software development company known for its Java applications. Oracle is the market leader in cloud, license, hardware, and services selling cloud-engineering solutions and databases. Semiconductors’ shares offer the highest return possible for investors.
Oracle’s revenue jumped 6% over the same quarter last year. Oracle boosted its cloud services and support business with revenue growth of 6%, augmented cloud leased software revenue by 15% and non-GAAP revenue grew by 14% to $0.91.m
Oracles’ 6-month chart appears fairly stable apart from the dramatic drop to $40 during the March lows in coronavirus prices in the US. The multinational company didn’t make a big industry announcement but simply continued to do its job as usual.
For the most effective call play, Oracle might be the right option. Profit from dividends that remain less than 1.75 %. The best way to keep the stock in place during sales calls is to capture a dividend and increase earnings as it helps buffer losses on stock positions. Day Range.74.57-77.22 52. WK Range 63.76-98.19. Close/ Open76.98 / 7265 Vols. 4.95 M – 7.25 M.
2) Pfizer Inc. (NYSE: PFZR)
Pfizer is a biopharmaceutical research and development business. It is active in developing, manufacturing, marketing, sales, and distribution of pharmaceutical drugs and biotechnology. The company’s global product line covers pharmaceutical products and vaccine products. Learn about vaccine stocks that you can buy today.
The Company released its fourth-quarter 2018-2019 results, which reported strong results. Total revenues were a 109% improvement on last year and grew by 7% year-to-date. Earnings were compared with the prior year’s earnings of $0.06. Pharmaceutical stocks have been growing rapidly during these past years.
3) Advanced Micro Devices (NASDAQ: AMD)
Advance Micro Devices is an international semiconductor firm. The business segment includes: It published its 2019-2021 annual financial results with total revenues of $6.6bn, an increase of 68% in comparison to 2020.
In addition, the business reported significant gains in its profits, with net profits reaching $3.2 billion and earnings per share reaching $2.56. Operating revenues grew by 229% to $43 a share, the report compared with the previous year. AMD recorded an increase in free cash flows of 334 percent.
4) Ford Motor Company (NYSE: F)
Ford is an automobile maker which develops, manufactures & markets Ford vehicles and luxury cars, and Lincoln SUV models in the US. The company operates in four sectors namely: The corporation has announced its first quarter 2018 results.
It is expected that revenues will rise by 5% over the previous quarter mainly thanks to increased net pricing and a mixed improvement from last year. Earnings for each of the companies amounted to 0.27 per share. There is much emphasis on long-term stock investing. The company will open new growth avenues this year.
5) ConocoPhillips (NYSE: COP)
ConocoPhillips is involved in worldwide exploration production, transport, and sale of sludge, and natural gas liquids. The solar industry dominated the gains for the quarter. ConocoPhillips reported exceptional operating performance in its fourth quarter 2021 results.
The firm generated high returns and capital for shareholders and completed two significant high-accretion acquisitions in the heart of the Permian basin. In the fourth quarter of 2015, the company reported $8bn adjusted profits of 2.27 per share. ConocoPhillips gave shareholders a $2 billion cash dividend.
6) Verizon Communications (NYSE: VZ)
Verizon is a global leader in communications technology. It has two sections – consumer and business. Tech stocks are an ideal investment choice.
The firm reported strong financial results for its third quarter. The company said its revenue declined by 1.4% in the year. underlying revenue was $13.11, which is up 8.7% from the prior month. The company’s 2022 forecast remains positive.
7) Devon Energy (NYSE: DVN)
Devon Energy is one of the leading oil and gas producers in the United States with the largest multi-basin portfolio anchored by acreage in the Delaware basin. Devon’s disciplined cash-flow strategy is focused on generating strong returns, creating free cash flow, and returning capital for shareholders.
According to the CEO, these guidelines are positioning Devon to become a prominent and consistent builder in the cycle of economic growth. Find out which crypto mining companies are the leaders in this area.
8) Nvidia (NASDAQ: NVDA)
NVIDIA is the manufacturer and developer of graphics cards. A range of GPU graphics processing products is provided to supercomputers and AI acceleration and rack-mounted software applications for GPGPU. NVIDIA produces the best graphics card in use for the GeForce brand.
NVIDIA’s GeForce gaming engine has more than 200,000 gamers worldwide. NVIDIA released its 2019-2022 financial results. Revenues in its first quarter climbed 31% over the same period last year. Net Income was $3.33 billion and Earnings per share were 6.1 – 3% more than last year.
Walmart, Inc. operates a worldwide retail distribution business. The company operates in three sectors: it manages supercenters, supermarkets, hypermarket warehouse clubs, cash-and-delivery stores, and discount shops. The company offers customers the convenience of online or offline shopping.
Covered calls can be used to lower your cost basis or to generate income from stocks or futures contracts. When you employ one, you add a profit generator to your stock or contract ownership.
A covered call can be a relatively low-risk way to use options to generate income, and it’s often popular with older investors who don’t want to sell their positions but would like some income. With a covered call, you’ll earn a limited return in exchange for running an often-limited risk.
Like any strategy, covered call writing has advantages and disadvantages. If used with the right stock, covered calls can be a great way to reduce your average cost or generate income.
Finding the right stock to buy for a covered call strategy is a critical first step, but there’s more to covered calls than picking a stock and selling a call option. For example, how much money should you allocate toward a particular stock? What strike prices should you use? And, what do you do if the stock falls in price and you don’t want to own it?
The answers to these questions could take up an article of their own—and we cover many of them on this blog. So, stay tuned…
About the author
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