Golden Rules for Covered Call Option Writers - dummies

Golden Rules for Covered Call Option Writers

By Paul Mladjenovic

Just as there are rules developed for call option buyers, option writers also have some rules for covered calls. Remember a call option is a contract that gives the buyer (holder) the right — but not the obligation — to buy 100 shares of an underlying asset at a given price (the strike price) on any business day before the option’s expiration date.

  • Even if you qualify for doing uncovered (naked) call writing, don’t do it. The most you can make is 100 percent of the premium, and your potential loss is unlimited (or, at the very least, quite substantial). Naked call writing is the most dangerous option-writing strategy.

  • If your intention is to hold onto the stock or security, write a covered call that puts the odds in your favor. Make sure the call is out of the money (or OTM). An OTM call is less likely to be exercised than an option in which the stock’s market price is at the same level as the option’s strike price (at the money, or ATM) or in which the market price is above the option’s strike price (in the money, or ITM).

  • As a point that augments the preceding rule, make sure the covered call you write has a relatively short time frame. A three- or six-month call is less likely to be exercised than one that is nine months or a year long.

  • Use technical analysis where applicable. It’s better to write covered calls on stocks or other assets that are considered overbought. An overbought stock is less likely to have the momentum to continue rising and risk being exercised at the strike price. In general, overbought stocks have RSI readings that are over 70.