How to Sell Covered Calls

This article first appeared in the June/July 2011 issue of Morningstar Advisor magazine. Get your free subscription here.

Covered calls garner a good bit of interest from investors focused on squeezing income out of their equity portfolios. Here's how to get the biggest bang from your buck when entering into one of these option overlay strategies. For more details on covered calls, view my recent 45-minute web seminar titled "Covered Calls from A to Z." It's free at http://www.morningstar.com/goto/coveredcall.

1. Understand the Risks and Rewards of the Strategy
Many people misconstrue covered calls as a way to take profit on an underlying asset that has made a capital gain. Certainly, selling a covered call means that one cannot participate in the underlying asset's upside potential, and in that sense, it is similar to selling the asset.

However, once you have sold the upside with a covered call, you are still left with the asset's downside risk. If the asset overlaid by the call option takes a dive, the covered-call seller is exposed to that loss. In return for accepting downside risk, a covered-call seller receives option premium up front, but this only serves as a cushion to damp the downside risk. It may surprise you that entering into a covered call actually means accepting the same risk an insurance company does when it writes a policy on a client's asset. If the asset decreases in value, you as the insurer own it; if everything is OK, your client enjoys its use.

2. Select the Asset
The risk in a covered-call strategy is the downside, so it follows that you want to pick assets to cover that don't have much downside. Also, if you are selling insurance, it is best to insure something on which people are very keen to avoid suffering a loss. With these guiding principles as a base, try to find assets that:

• Have some hard economic "floor." In stocks, we look for companies that have a good chunk of cash, a secure dividend payment, or a stable economic moat.
• Are undervalued-a 4- or 5-star rated stock, for example. It seems a shame not to participate in the upside movement in an asset, but remember that we are insurance sellers, so care less about the upside than in getting stuck with the downside.
• Have taken a big price fall recently for purely cosmetic reasons. As demand for insurance increases, people will pay more for it; we want to find assets to insure that others are worried about but which we are not. When a 5-star, wide-moat stock misses its quarterly earnings target by a penny because of an accounting technicality and its shares take an unexpected hit, there is likely opportunity.

Many clients want to sell covered calls on stocks that are already in their portfolios, but they usually can generate a better return by setting aside a portion of their portfolio solely for funding good covered-call candidates.

3. Select an Expiration
Call options are contracts with definite ending dates. We find that selling calls in the six-to nine-month range usually provides the best trade-off between absolute amount of downside cushion (that is, premium income received) and annualized return. Be cautious of using annualized return as your sole determinant of an expiration to choose. Just because you can make a nickel in two days, it does not follow that you can make a nickel once every two days for the rest of the year.

4. Select a Strike Price
A strike price is the price at which the covered-call seller has agreed to deliver the asset to the call buyer. An option whose strike price equals the market price of the asset is said to be "at the money." It turns out that the at-the-money strike is the best to sell because it gives the seller the greatest premium income with the least chance of owning a "damaged" asset at the contract's expiration.

Erik Kobayashi-Solomon is a market strategist with Morningstar and co-editor of Morningstar OptionInvestor. For a free two-week subscription, go to http://option.morningstar.com