When you write covered calls, you can produce greater profits by writing six two-month covered calls per year, than you will realize writing one 12-month covered call per year. Time decay for further-out options is quite slow, so writing options more than few months away is equal to lost time. Based solely on option premium profits, focusing on short-term ATM or OTM contracts produces annualized double-digit returns.
An example of the covered call and how to identify profit, loss and breakeven points: You purchased 100 shares of stock two months ago and paid $54 per share. Today those shares are worth $58 and you decide to sell a covered call with a strike of 60 and expiration in two months. You receive a premium of 3 ($300).
In this example, you have several crucial price points. Your basis in stock was $54, but because you received 3 for selling the call, you net basis is reduced to $51 per share. This is your breakeven point and if the stock price moves below this level, you will have a paper loss. With a strike of 60, your potential profits are limited as well. If the underlying stock moves above 60 and the call is exercised, your profits are limited to:
Capital gain on stock:
Exercise price, 100 shares $6,000
Less: Purchase price – 5,400
Capital gain $600
Profit on the covered call 300
Maximum profit if exercised $ 900
If the call is not exercised, you keep the $300 as profit. And when the call expires or when you close it, you are then free to create another covered call with a later expiration date.
Another test that makes sense is to limit covered call writing to companies whose dividend is higher than the average. As long as the company is fundamentally strong, the larger dividend adds great value to the covered call position.
It makes sense to take two steps aimed at avoiding early exercise. Don’t open covered calls that expire the week of dividend ex-date. If the calls ends up in the money the day before ex-dividend, there is a chance it will be exercised by a buyer employing a dividend capture strategy. It does not always occur, but it could. Second, avoid having open near-the-money covered calls when earnings are announced. That week is potentially volatile if an earnings surprise takes the stock well above the strike. This also could cause early exercise, even when price rapidly retraces back to an established range.
Both of these conditions – dividend date and earnings announcement – represent “danger zones” for anyone preferring to exploit time decay as part of the covered call strategy.
Finally, pick companies based on their strong fundamentals. These should include dividends (per share rising each year; yield between 4% and 6%; and payout ratio consistent over several years); P/E annual range between 25 and 10; increasing revenue and earnings; and steady or declining debt capitalization ratio.