Writing covered calls is an extremely useful technique to generate monthly income from your investments. This technique works best in neutral or slightly advancing markets. In bear markets, it may be wise to utilize other techniques.
When you sell a call, someone pays you a premium for the right, but not the obligation, to purchase your shares at a certain price (known as the strike price), on or before a certain day (known as the expiration date).
1. Buy 100 Shares – In order to write a covered call, you must own 100 shares of the underlying stock. Writing covered calls without owning the underlying stock is an extremely risky technique known as going naked. I would strongly advise you not to try this. Instead, just buy the shares.
2. Immediately sell 1 call – For every 100 shares that you own, you can write 1 call. Many online brokerages have built-in features that allow you to purchase 100 shares and sell 1 call at the same time. This is the method I prefer, since my trade will not be executed unless I get the shares at the price I want. Once the trade has been completed, you should see the premium income from selling the call in your account. You are free to do whatever you want with this money.
3. Determine your next step – At the expiration date, determine what you need to do. If the price of the stock has risen above the strike price, you will be called out and you will receive your investment back. If the price of the stock has fallen, or has not reached the strike price, you will not get called out, and thus, still own the stock. As an added benefit, you also get to keep the premium income you received when writing the call. In this way, writing covered calls can be truly profitable.
4. Review your options – If you are called out in step 3, take the money you receive from the sale of your stock and find another company to invest in. Repeat the process as documented above. If you are not called out, sell another call on this stock and earn additional income.
Writing covered calls take a lot of practice. Try to make a profit on paper before using real money. Try and achieve a 3 – 5% monthly return on your investment. Remember to always set a stop-loss on your stock at 10% below your purchase price. When a stock drops quickly, you can lose a lot of money.