Covered calls are a relatively risk free way of increasing your returns

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Writing covered calls on optionable stocks you have purchased may be just the option trading strategy you are looking for to increase your annualized return. When you sell calls against your optionable stock it is your choice which call you sell. Building a portfolio of optionable high quality stocks is a good way to have a source of reoccurring income and if done properly may be more desirable than buying bonds. This is one way to create residual income for yourself.

The Option Trading Game

Not all stocks are optionable, however there are many websites which identify the ones that are. By writing a covered call you are reducing your downside risk at the expense of your upside gain.

For example, assume you purchased 500 shares of Home Depot on November 18, 2006 at $38.20, as it broke out of a short term consolidation pattern. After you purchased the stock, you then sold 5 May 40 calls against your 500 shares. Each call controls 100 shares of stock. If you received $170 for each call, you would have received $850 which would mean that you actually only paid $36.50 for each share of HD. All of these examples have not taken commission into consideration.

Now forward to the close of the market on May 18, 2007. If HD is below $40, you keep the 500 shares of HD stock which you own and the $850 you received in premiums. However, if the stock is above $40, you still keep the $850 but have to sell the stock at $40. It is said to be called away from you.

Increased Downside but Limited Upside

Therefore, by selling a covered call against HD, you have reduced your downside exposure by $1.70 per share but limited your upside potential to $3.50 (1.70 + 1.80) per share. Also, if you still own the stock at the end of trading on May 18, 2006 you are free to sell another call against the stock and repeat the process.

The premium you receive for your stock is mainly dependent on the amount of time value left in the call, the strike price, the perceived volatility of the stock and current stock market sentiment. As the premium varies among stocks, some stocks are more suited to writing covered calls than others. It is a good idea not to initiate this strategy on a stock that is in a downtrend or appears to be bearish.

Dividends

As Home Depot pays a dividend, you may be wondering who gets the dividend after you write a call against the stock. As long as you own the stock you will receive the dividend. In some cases, someone may call the stock away from you just prior to the dividend date such that they can receive the dividend.

To understand a bit more about covered calls you need to know about call options.

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