Producing Portfolio Income by Writing Covered Calls

Investors who hold individual securities will have certainly noticed that periods of continued strength normally end with a period of weakness, and following the weakness the cycle starts again. An ideal options strategy would be to sell covered calls in periods of strength and either let them expire or buy them back in periods of weakness.

Selling covered calls when a security is peaking is not a new strategy. It certainly is a popular one, mostly due to the fact that investor can maintain control of the underlying security and continue collecting dividends (if applicable) and, in some cases, the option expires worthless or it is bought back at a lower price. Even if that option is exercised, the investor often gets out of a position that they should have gotten out of anyway but stayed invested because they wanted to see more and more growth (alternately known as greed).

Measuring Strength

One way to measure whether a security is trading on strength or weakness is by using Bollinger Bands or by measuring a security’s price against is moving average.

When shares are trading on strength and seem to deviate by a large margin from its mean (either it is trading at or above the upper Bollinger band or well above its moving average), the common belief is that the security will start trading on weakness. This means a pullback of some type is due and the security is expect to drop in price, at least for the short-term until the Bollinger bands and/or moving average adapts to the new trading range.

What Call Options to Sell/Write

The best strategy when it comes to writing covered call options is to write them slightly out of the money, particularly after a period of aggressive price appreciation. This serves two purposes. One, it allows for additional profit should the security continue to appreciate. And two, it maximizes the premium of heightened volatility.

Since volatility plays a tangible role in options pricing, the more the security deviates from its mean, the more costly the option will become. Not only will the investor benefit from continued price appreciation, but will earn a greater premium on the written option.

Common Risks 
Risks to covered call options is that the underlying security drops so much in value that the premium income does not replace the loss (which could also happen without writing the call). Another risk is the opportunity risk associated with the security shooting past the strike price so far that the investor misses out on those gains because the option will be “called.”

Regardless of the risks above (a normal one as well as an opportunity risk) writing covered call options allows the investor to capitalize on abnormal price appreciation in their portfolio. As well, this is a fairly straightforward practice and, while common, is used by millions of investors every day.

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