Options Forum: Covered Calls 101

This is not to say there isn't an appropriate time and place for writing calls. Here are some things to keep in mind:

• Only sell calls with a strike price at which you are willing to have the stock get called away. This will help avoid rolling up the calls, which can leave you owning the stock with incrementally higher effective prices and incurring mounting transaction costs.
• Look for stocks with volatilities that provide at least 5% immediate downside protection or at least a 15% annualized return. To get the 5% downside protection might mean going out to longer-dated options whose higher prices provide a greater absolute dollar amount of protection.
• But the item above runs counter to the notion that when volatilities are low, you should look to write short-term options. By avoiding writing long-term options, we hope to prevent locking up capital or committing to a covered-call with low risk/reward profile for an extended period. In a low-volatility environment, you should look to write short-term calls, which can then be replaced by options with richer premiums if volatilities increase in the future.

One goal of using options as a hedge or income-generation strategy is to reduce or completely eliminate "trading"-type decisions. The process should be fairly mechanical and not vary with market conditions. In individual issues, this means setting target sale prices and demanding at least a minimal level of protection or compensation in exchange for reducing your profit potential.

In part 2 of this series, I'll look at applying covered calls as a means to reduce overall portfolio volatility and look at some of the products available for investing in a covered-call strategy for the broad market.