7 steps to covered call writing

Covered call writing is easy once you know how, however as with all things new it can be a little daunting at first. With a list of action items to check off against you'll wonder why you haven't been writing covered calls before. With that in mind here is our checklist.

1. Select a stock.
This is by far and away the most difficult part of the process. The reason we say this is because buying a stock or continuing to hold on to a stock involves a much bigger financial outlay than selling a call, put or any other combination of options. A poor or even a mediocre decision can be costly and no amount of writing options will protect against a sudden sharp drop in the value of the stock. It is recommended that you check the financial health of your stocks periodically, read research, and keep abreast of developments in the sector(s) in which the company operates.

2. Determine which option to sell.
The two choices which define an option are the strike or exercise price and the expiry month. Taking the strike or exercise price first.

The higher the strike the more you want for your shares. Of course we would all like to receive a high price however the higher / further away the strike (selling price) from the current price the smaller the premium. Taken to its extreme selling a call for a couple of cents adds little to the overall position other than to cap profits - something we want to avoid.  

The following table summarises the different options and premiums on offer for a short dated (1-3 month)options on an average price stock of $10.

In relation to the current share price Option Premium
Above the current share price Out of the money 5-20c per share
At / around the current share price At the money 20-50c per share
Below the current share price In the money 50c - $1.00 per share

The second term which defines an option is the expiry month. Covered call writers typically select an expiry date that coincides with their view for the stock. For example if the expectation is for the stock to rise over the next 2 months after which time it will be sold, then a 2 month will be sold.  In general covered writers prefer to sell short dated options more frequently than longer dated options less frequently. Short dated options earn premium more on a daily basis than longer dated options, earning sellers more premium.

In order to help determine your potential return from amongst a variety of options check out the covered call calculator. 

3. Put the order on:
Call your broker or go online. Most brokers will encourage you to place the order to buy and write as one order, however if you prefer to finesse the order attempting to buy the stock at the low of the day and sell the call at the high you can do this also. 

4. Lodge the stock with ASX via your broker as collateral to cover the margin liability arising from writing the call. Your shares need to broker sponsored on Chess for the shares to be accepted.

5. Dividends
Take note of the next dividend and when the stock is going ex dividend. This is vital as call options are usually only exercised early for the dividends on the underlying stock. 

6. Buy back the call before the stock goes ex dividend if the option is likely be to early exercised and you don’t want to lose the stock.  For more information on why calls are early exercised and the calculation involved.

7. On expiry. The wait is over and your options either expire in, at, or out of the money and the whole process starts over. If you don't want to sell your shares and your options are in the money then you will have to buy back your position. Take note of the expiry dates as after expiry it's too late.