Writing Covered Calls For Consistent Profits

by Mike Scanlin

Writing covered calls for income has been a popular investment strategy for investors since standardized option contracts were first introduced in 1973. Many investors are happy with a modest rate of return, as long as it's fairly predictable and consistent. Or, if you're a risk loving investor seeking extraordinary returns, it is also possible to use covered call writing more aggressively.

Writing Covered Calls The Conservative Way

Playing it relatively safe with covered calls means choosing underlying stocks with these attributes:

• Large market cap. There are 508 stocks with market caps over $10 billion. That's a good place to start. Even some mid-cap might be okay (if they are not 'story' stocks or momentum stocks). But conservative investors should definitely stay away from small-cap stocks.
• Pays a dividend. There are 396 stocks with market caps > $10B that pay dividends. Average annual dividend yield of these 396 stocks is 2.54%. These companies paid a total of $240B in dividends in 2011, up from $205B in 2010. Ideally, there will be an ex-dividend date prior to option expiration so that you get some dividend income in addition to the call premium.
• No earnings before expiration. This is only for new buy-write positions. If you are writing calls on your long term holdings then you can ignore this rule.
• No FDA announcements. Much like earnings, FDA approvals (or lack of) can move a stock dramatically. Too volatile for conservative investors. See FDA Calendar.
• Only buy stocks you are comfortable holding for many months, even if you are doing in-the-money buy-writes.

Construct a portfolio of large cap dividend payers and then write in-the-money calls and you should have a portfolio that will deliver consistent income. A conservative rule of thumb is to target covered calls paying 12% to 24% per year (1% to 2% per month).

Writing Covered Calls The Aggressive Way

More aggressive and/or risk loving investors, which includes anyone seeking more than 2%/month, can adopt this style of writing covered calls:

• Write at-the-money calls instead of in-the-money calls. You'll get better returns but have less downside protection. If stock is flat or goes up (before expiration) then you'll maximize your time premium.
• Write calls on momentum-based stocks (not recommended if you are risk or volatility averse!). In the past this would have included high flyers RIMM, FSLR, and NFLX. It's great while the momentum lasts but painful when they reverse (even if you're writing deep in-the-money calls). Having a stock crater 50% or more is difficult to recover from with covered calls (see Stock Repair).
• Seek the highest annualized yield without regard for what the underlying company does and without understanding why the premiums are so high. Do your homework and understand what's going on with the company before you buy.
• Trade on margin. You can always increase returns (and risk!) by adding more leverage. If you have over $100K then some brokers will give you Portfolio Margin, which is about 5.6x leverage (compared to 2x leverage normal Reg T margin gives you).

While it is *possible* to earn 4% to 6% in a month with covered calls, those kinds of returns are unlikely to be reproducible over a large number of months. Most people claiming such results are using heavy margin, or are playing with high beta (volatile) stocks, and do not have consistent month to month returns. Realize that 5% per month is 60% per year. Common sense says that's not realistic (or possible) over the long haul.

Covered Calls For February Expiration

Here are a few covered calls to consider for the Feb 18 expiration:

Mike Scanlin is the founder of Born To Sell and has been writing covered calls for a long time.

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