While often done on an ad hoc basis, one can assemble and manage a portfolio of covered call option positions as either a part of a larger portfolio or on a stand-alone basis.

Such an approach does require more detailed attention than managing a stock-only portfolio. Nonetheless, systematically managing a portfolio of covered calls has much for me to recommend it. If the stock remained at its current price level no price appreciation , the return would still be about 8.

Even this lower-level return seems attractive compared to current rates on most fixed-income instruments. Covered writing does incur some risks. One might, for example, write a call on a stock whose price then drops by much more than the sum of the proceeds from the call sale and dividend payments.

Covered Calls - Born To Sell

Alternatively, the price of the optioned stock could increase substantially once the position is established. Clearly, option writing involves significant risks. But what type of investing offers attractive returns with no risk?

Covered option writers should not be expecting home run—like returns. Rather, their objective should be to earn reasonably attractive and steady returns with a limited amount of risk.

To pursue this objective effectively requires attention to detail both when setting up the positions and when monitoring them over time. If a call is written against an existing stock position and ends up being exercised, the gain or loss on the stock represents a capital gain or loss for the investor. The marginal rate on ordinary income rises to If a call is written and expires worthless or is covered with an offsetting purchase, the difference between its sale price and the cost of covering zero if the call expires without being exercised is classified as a short-term gain or loss regardless of how long the call position was in place.

IRS classifies a trade that starts out with a short sale as short-term regardless of whether the sale is said to have preceded the covering purchase. Clearly, the investor would prefer to have income in the form of long-term capital gains rather than taxed as ordinary income.

Consider what types of stocks tend to be attractive option writing candidates. Since one of the main sources of return for option writers is the dividend, stocks selected for covered writing should have generous and secure dividend yields.

Not only does a high dividend yield provide a significant part of the desired return, if it is sustainable, the dividends will also tend to support the stock price even when the overall market is under pressure.

Only if the company itself has a strong position within its served market and earns a profit rate that comfortably covers the dividend does a generous current dividend rate provide the kind of protection that is likely to limit losses in a declining market. Preferably, the company would not only sport an attractive and sustainable dividend yield but it would also have growth potential.

The covered option writer could then seek to capture some of this price appreciation potential by writing calls that are a bit out of the money strike price above current stock price. In summary, stocks with generous and sustainable dividends that are expected to grow generally represent attractive candidates for a covered option portfolio. Stocks selected for the Dow tend to be mature industry leaders, most of whom pay relatively generous dividends that they tend to be able to maintain.

The 10 with the highest yields are called the Dogs of the Dow, most of which would be classified as value stocks. AAII tracks a Dogs of the Dow screen that lists the current Dow dogs, along with their indicated dividend yields, at www. Dividend aristocrats are stocks that have increased their dividends annually for at least the last 25 years.

Clearly such stocks are very likely to have sustainable dividends, based on their past performance. Dividend aristocrats with high yields are reasonable candidates for covered option writing.

Options are not written in a vacuum. In particular, stocks with a modest degree of anticipated volatility and high dividend yields tend to have lower call prices than more volatile stocks with little or no dividend yield.

Still, if the objective is to produce consistently attractive returns, sticking to less-volatile stocks with decent dividend yields is probably a good idea.

Options can be written at various strike prices and with various lengths to expiration. The further the option is out of the money, the greater the potential upside from price appreciation, but the lower the market price of the option. Selecting a higher strike price option could result in a significantly greater upside. This greater upside may seem attractive.

But if the stock price falls or does not rise much, the lower strike option would have produced a better outcome. The call writer must also decide how long an option to write. While the market price increases as the term is lengthened, the rate per month usually declines as length rises. Thus the option writer might be able to earn a somewhat higher return per period by writing shorter-term options. Such an approach has some significant disadvantages, however.

Specifically, the more times one must buy and sell options and stock, the greater the transactions costs and the greater the likelihood of adverse tax results. Moreover, one can get whipsawed by short-term price fluctuations. So option writers should generally set up their initial covered call positions with relatively long-term options.

Best Stocks for Covered Calls, Call Writing Stock Selection

Writing one-year options is a pretty good place to start. That way if the stock reaches the strike price and is exercised, the position will give rise to long-term capital gains, which are taxed at a favorable rate.

Generate Safe Income With My Covered Call Options Strategy

Moreover, writing one-year options gives the situation time to evolve favorably. That is, the stock has a reasonable opportunity to rise and the investor can hold the stock long enough to earn several dividend payments. First, compute the return if the stock is at the same price at option expiration as it was when purchased.

In this case the gain would be equal to the sum of the dividends to be received plus the proceeds from the option sale. The return would be this gain divided by the cost of the position.

For example, if the stock had a 3. An attractive covered position should generate a decent return in this circumstance. This is the same percentage number as the gain on the transaction if the stock price did not change.

That is, the sum of the dividends and proceeds from the option sale. Note that if the stock falls further, the position will show a loss. Third, compute the maximum gain on the position: For a nine-month call, the annual return is this sum divided by the cost of the position, which has already been calculated above.

The covered option position should only be established if the investor finds each of these calculated numbers attractive. When a company declares a dividend, it establishes the day that determines who receives that dividend, referred to as the record date.

Those who are on record as owning the stock on that date will be paid the dividend even if they sell their shares before the checks are sent out. Because settlement of trades takes three business days, you must have purchased the stock three or more days prior to the record date in order to receive the dividend. The first day after the last day for owning the stock and being paid the dividend is called the ex-dividend date.

Those who trade options need to keep an eye on ex-dividend dates of stocks on which they have written options. If the call owner chooses to exercise the option just before the ex-dividend date, they will capture the dividend.

If they let it pass, the covered writer will receive it. In a portfolio approach to covered writing, the objective would be a set of outcomes that were not only generally positive, but provided a relatively steady and attractive return. On the other hand, in a declining market, the income generated by option writing coupled with the type of solid dividend-paying stocks selected for the portfolio would generally cushion the impact of the weak market such that the overall portfolio return would be significantly above the market averages.

Finally, in a directionless market, the strategy should generally outperform the market averages, as the proceeds from option writing would add to the returns on the long stock positions without leaving much money on the table from those few stocks that did well in a market moving sideways.

I used to run this strategy with SPY. To make it simple, say if I own shares of SPY and write one contract of covered call. I'll collect a premium of the call. However, each time SPY paid a dividend, the brokerage firm deducted the dividend for the call i. I asked the brokerage firm why I should pay the dividend for the call position, the customer service did not have a clue why.

But I figured it might be caused by the price drop due to the dividend paying. Anyway, my expericence is that if you write a covered call, you won't collect any dividend before the expiration date of the call.

Was I ripped off by the borkerage firm? HiVL The only time I have had a dividend deducted is when I shorted SPY as a hedge against a market correction. If you own shares of SPY you should be paid the dividend each quarter on the covered position.

The short call option should generate no dividend activity. OK, I think the following discussion explains what happened to my covered call positions: If your calls are in the money, even barely, your options may be assigned right before the security goes ex-dividend—and then you may have a problem Am I missing something? This is caused by lower volume which can make these trades difficult to fill at favorable prices on the short calls.

Return results of course will vary with performance of your selected stock. If the market goes up significantly as in , you would have been better off owning the stock outright of course, hindsight is so easy to judge. A big drop in your stock can result in some significant losses. Do check your x dates as if you are ITM in the money chances are you will be called away as the buyer of your call is looking to capture the dividend on the stock.

If you are called away, congratulations! Just buy the stock and repeat the process. If you can always pick the stocks that are going to go up, you should be buying calls not selling them: I try to sell covered calls on stocks I want to hold, but only when the charts tell me that a short-term drop in price is likely.

When I think it's going to go up, short term, I stay naked long stock.

VL, yes if the option is in the money right before the ex-dividend date, and will expire that same month, you are very likely to be exercised. I always look at the ex-dividend date compared to the option expiration date, and try to avoid that situation. Sell the next month out instead. The dividend capture people likely want to get their dividend right away, not wait a month for it. When you trade options, you have to know about "the Greeks": Selling covered calls, theta is key: Theta for out of the money calls is highest close to expiration.

It is often recommended to sell the call with days to expiration, so theta can work harder in your favor. It's still income generation, but with more of a trading flavor to it. And then you can sell the next month's option on the same position.

I'm rather new at options and don't understand all the techniques. Does this always happen? If the stock price is below my strike price at expiration, then I may keep the shares of stock and receive the premium on the option plus any dividends.

And I can choose another strike price and expiration date and sell another call. What level of trading do I need for the broker to accept this trade? Elmer, Covered calls are not considered risky.

Approval from the broker shouldn't be a problem. Selling naked options requires much more experience to get approval nowadays. As for "Does this always happen? I have had some stocks not called or a partial exercise if the stock is barely in the money. For individual investors that own the options, the broker will automatically exercise in the money options unless the customer instructs otherwise.

Commissions have been neglected. Of course commissions vary from broker to broker and the first call is the highest with subsequent calls at a lower price. I find it best to buy at least shares and in multiples of as each call is for shares. I also have a spreadsheet with calculations to show the annualized return for both the stock called and not called at the Monday following the expiration date.

William Myers comment is correct. The 9 month return is 3. Annualized that is Also, generally the advice is to sell calls with about a month to go, and to understand the greeks. The CBOE website offers an excellent education series on options, including covered calls.

It's free and thorough.

I have been doing these strategies for a few years now, but in a rising market, selling covered calls on your income generation is not always the best bet, because you will eventually get stopped out of your income producers and then need to buy them back at a higher price less yield.

Sure you might make a little gain, but the long term outlook is not that good. A better strategy is once one of your good stocks is sold due to an exercised option, you should go short a put on this stock, at a price that you would want to own it.

There is usually more premium in a put and thus you can afford to not worry about the lost dividend. There is also no need to wait for the option to expire. When I double my money, I usually just buy it back and roll up or out to the next option. If the market turns on you and you own the stock, well you are back to covered calls, but this happens less often in an up-trending market. Being retired, I don't do this year in and year out, because you have to watch your options.

Ben Branch, Thank you for an informative article. Please clarity some points. This represents a simple yield of The call income seems to be considered twice in this example. I see others have picked up on these anomalies. Also, For those that are practicing or considering this strategy, there shouldn't be any regrets about limiting your profit when the stock price exceeds strike.

This is an income strategy NOT a growth strategy. Consider it a good day should you have your stock called away at expiry when the price exceeds strike. Spot on analysis and insight.

A good strategy that I employ from time to time even for non-div stocks. I'm considering MKX puts for Monday trade. It's not easy to find these stocks. I have been selling covered options for about 3 years now. The first year I went very carefully and conservatively. And the market has generally been bullish in this time frame. The discussion in this thread has used Blue Chip dividend stocks for underlying stocks.

I use the technique with several good underlying stocks like T, VZ, LLY, MRK, XOM and a few others. As I have gained more and more experience with covered options, I have been using more speculative stocks.

Granted, there is more risk and I have had some losers but I have also had some very big winners including more speculative stocks. When I started using this technique with more speculative stock, I moved into In The Money options.

One can receive really good downside protection on those stocks because the premiums are so high. The last 18 months I have been able to beat that goal. This strategy works fantastically in a rising market. In one that's going down, it's not going to work so well, as the price of the underlying may decline more than the sum of the option premium and captured dividend. If the price of the underlying stock dips below the strike price of the option is the stock automatically called away?

Can you buy the option back prior to exercising? Paul, The stock is only called away if the option holder chooses to exercise his call option. It is possible that you will be able to close your option position before the stock is called, but doing so is not guaranteed.

The outcome depends on how quickly you act relative to how quickly the option holder acts prior to expiration. Going back to early post. The author is correct. If you don't include the premium how would you ever make money as in or at the money.? You need to log in as a registered AAII user before commenting. Editor's Note Editor's Note A look at what's in the June AAII Journal.

Features The Tax Consequences of Stock Splits, Mergers and Spin-Offs Tracking cost basis becomes complicated when splits, mergers or spin-offs occur. Merck provided a real-life example of how to do it. Mutual Funds Qualitative Guidelines for Mutual Fund Selection Looking at the type and frequency of communications, portfolio holdings, manager stability and expense ratio caps can help with the fund selection process. Mutual Funds Achieving Greater Long-Term Wealth Through Index Funds Index investors, in aggregate, are likely to realize higher returns because of lower costs and the effect of reversion to the mean on active strategies.

Trading Strategies Assembling a Covered Call Portfolio on Dividend-Paying Stocks Dividend-paying stocks are attractive option writing candidates since the goal of a covered call portfolio is to generate income. Trading Strategies Analyzing the AAII Sentiment Survey Without Hindsight Based on the values that existed at past periods of time, above-market returns occurred after unusually high levels of neutral and low levels of bullish sentiment.

Stock Strategies How I Analyze Net-Nets: Stocks Trading at Deep Discounts Stocks hitting week lows of companies with strong balance sheets and past profitability can offer big upside returns.

Financial Statements Valuation Ratios: Member News Member News Our annual update on AAII programs and services. How Do Taxes Impact Call Writers? Who Gets the Dividend? VL from CA posted over 3 years ago: William Newport from HI posted over 3 years ago: GRE from VA posted over 3 years ago: Dave Samuels from CA posted over 3 years ago: John O'Connell from TX posted over 3 years ago: Elmer Stahlecker from Kansas posted over 3 years ago: Larry Sealy from AL posted over 3 years ago: Rodman Johnson from TX posted over 3 years ago: Allen Evans from ME posted over 2 years ago: Dave Gilmer from WA posted over 2 years ago: John Atta from NJ posted over 2 years ago: John Attanasio from NJ posted over 2 years ago: Herman Sabath from CA posted over 2 years ago: Dennis Black from Texas posted over 2 years ago: Nord from CA posted over 2 years ago: Paul G from Florida posted about 1 year ago: Charles Rotblut from IL posted about 1 year ago: Create an account Log In.

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