It's been a while since we've looked at the
Equal but Not the SameTo qualify as a valid covered call, both the stock and the option must be in the same account, the long stock must be the same underlying security specified by the short option, and you must hold at least enough shares of stock to fulfill the delivery requirement of the call option. These criteria are important because they determine in what type of account the position can be established, as well as the margin and maintenance requirements.
I've mentioned these requirements because some people will point out that selling a put option short (i.e., "naked" or uncovered) offers a similar profit/loss profile as a covered call but requires less capital and can be established through a single transaction. But it's important to note that many brokerage firms may not allow individuals to sell naked options because they're more highly leveraged and therefore, in percentage terms, a riskier position.Also, for stocks that pay a dividend, using a covered call can be more valuable than selling put options, because owning the underlying shares let you collect the dividend payments. For example, despite posting strong earnings this morning, shares of J.P. Morgan ( JPM) were down 1.5% and tumbled a full 10% over the last three weeks on concerns that rising rates will hurt performance. But at current levels, the stock provides a dividend yield of 3.6%, making it an attractive core holding. By writing calls against the long stock, you can reduce the short-term risk associated with interest rate concerns and hopefully generate some incremental short-term income.
Get Paid to Assume RiskWhen looking at any option position, it's always important to look at the current implied volatility relative to the underlying stock's historical or actual volatility -- not just the absolute number -- in determining whether on option is "cheap" or "expensive." The theory is that if you're going to take on risk, you should be paid accordingly. Selling "expensive" calls against a long position in the underlying shares is one way to add higher-risk stocks while reducing exposure. Selling the call not only cuts your cost basis but also establishes a way to make profits at a specified price level. One way to find attractive covered call candidates is to screen for stocks that have declined at least 20% over the last 30 trading days and have options with an implied volatility that is within 10% of their 52-week historical high. It's not too big a surprise that the technology sector has proved the most fertile ground for generating names that meet this basic criteria.
For example, on Wednesday morning Foundry Networks ( FDRY) was trading at $16, down some 31% from its March 10 closing price. Its May $17.50 call was trading around 80 cents, or $80 a contract, giving it an implied volatility of 69%; this is well above the 30-day historical (actual) volatility of 50%, and just 8% shy of the 52-weak peak of the 75% hit on March 16 when the stock took its initial tumble, but well above the 42% implied volatility hit last December.A current covered call position in Foundry Networks, in which you can buy the shares at $16 (a level that seems to offer some technical support) along with selling the May $17.50 call, seems like an attractive proposition. It provides a break-even point of $15.20, or a 5% discount to the current market price. The maximum profit, or the crossover point at which the gains in the long stock will be offset by losses in the short calls, is $18.30, which would be a 14% profit (excluding commissions, margin requirements and so forth). That's not bad for four weeks of work, translating into a return of 172% on an annualized basis. Given its recent drubbing, Nokia ( NOK) also might be right for creating a covered position. There is certainly a case to be made that at $15, the stock currently represents value. But when a stock gets knocked down by about 25% in the span of three days, it may take some time to stabilize. On Wednesday morning, you could sell the May $15 call for 70 cents, not the richest price with 36% implied volatility, but a nice way to generate income of 5% off a stock that may be mired at current levels and needs a month to mend.