How To Write Covered Calls

By Mike Smith

It is amazing to me that not many retail investors understand the concept of generating cash flow from their stock positions. When I tell people that I utilize covered calls to generate extra income, hedge my stock positions, and set strict sell disciplines they look at me like I am crazy. I was introduced to the concept from a stockbroker. The idea of writing covered calls is the only option strategy that you can employ at most of the major brokerage firms for your IRA investments. The reason is that writing covered calls is a very conservative strategy relative to other option strategies.

Covered call writing is very simple to understand. It basically says that I'll give you $5,000 now, if you allow me to buy your stock 3 months from now at a certain price. If I choose not to exercise this option, you keep the money and we part.

Now I will go into more detail. Do not worry, just keep re-reading this until you get it. I buy 1,000 shares of FGH at $10 and the stock goes to $11 several weeks later. I can make money right now without selling my stock by selling the option to someone to buy the stock from me six months from now at $12.50. For that option, the buyer has agreed to give me $0.50 per share or $500 right now.

The cool thing is that I get the $500 immediately deposited into my brokerage account. The option position now shows up on my brokerage statement. I must not sell the stock prior to six months unless I buy back the option at the current market price. I usually hold my stocks until expiration because of how much the option price fluctuates from day to day.

Six months from now, two things can happen. First, the stock can go above $12.50 and the buyer of the option "calls" me out of the position which I happily do since I bought the stock at $10. The second thing that can happen is that the stock falls below $12.50 and the option holder is holding on to a worthless option. No option holder is going to "call" you out of the stock if it is $12.50 when he can buy the stock in the open market for $11.50 a share.

After the call expires, I then start all over again by writing another call again.

Are you beginning to see how cool this strategy is? Here is what I just accomplished. First of all, I lowered my cost basis by 5% or $500. Secondly, I drew a line in the sand and said this is what I'm willing to sell the shares for, $12.50. Third, I generated instant income that I could use for Christmas or just reinvest.

I can not tell you how happy this strategy has made me since the crash of 2000-2001. The strategy has helped me keep my head above water in this depressing market.

A good friend of mine is a computer programmer. He also shares a passion for covered call writing and has written a program that is in beta testing. I am his BETA Dummy. So far, the program has saved me countless hours of research and has narrowed my focus to a short list of 5-10 natural resource stocks to add to my portfolio quarterly. In future articles, I'll discuss some of my picks and income generated from the covered call strategy, plus provide a link to the option software.

But remember, any option strategy involves more risk than just buying a stock so always consult with a licensed financial adviser first. - 23212

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