If you own stocks, you can generate additional income by selling options against them. These are known as covered calls, and if applied correctly they can produce income for you in all market conditions, even when the stock’s performance is lacking. It’s a great way to lower your net cost basis over time and reduce overall volatility of your stock portfolio.
Call option contracts obligate the seller to deliver their stock to the contract owner, but only if the stock is trading above the specified price in the contract when it expires. This is called the “strike” price. If the strike price is above the market price of the stock when the option expires, then you – as the seller of this contact – get to keep all of the proceeds from the option sale.
The hard part is finding the right option to sell! You have to balance the risk of losing the stock with the reward of collecting the premium. That means finding an option that:
- Offers enough premium to make the option sale worthwhile, and
- Has a low probability of expiring “in the money,” meaning there’s a low chance that your stock gets called away
This used to very difficult to do, but now there’s a new indicator on OptionsPlay that makes it simple. It’s called the POW: Probability Of Expiring Worthless. This figure tells you what the probability is that the stock will not get called away. The probability is mathematically derived from the implied volatility of the option. In order to establish a consistent, profit-generating covered call program, you need to sell options that have a POW in a consistent range.
If you’re new to writing covered calls, then we recommend that you start conservative and select a POW in the 80 – 90% range. That means you can expect only about 15% of the covered calls you write to get called away. Depending on how volatile the stock is, you’ll find that these calls generally have a low annualized return of 2 – 10%.
Once you’re comfortable writing conservative covered calls, then you may consider more aggressive POW’s in the 70 – 80% range. This means you’ll face a greater risk that your stock will get called away – around 25%. But the greater risk pays higher annualized returns: Anywhere from 8 – 25%, depending on the volatility of the stock.
Everyone’s risk tolerance is different, so the key is finding a POW range that works best for you. Start conservative, and then gradually increase the aggressiveness of your POW until you find the right balance of risk and reward. If your POW is too low, you’ll notice that a lot of your stock is getting called away, which means you’ll have to purchase more shares to write calls again.
For conservative investors who want to minimize the risk of their stock being called away, I recommend staying in the 80 – 90% POW range. Our platform was built with this strategy in mind. When OptionsPlay Ideas recommends a covered call for you, it’s already found the one that’s closest to an 85% POW, has a minimum annualized return of 3%, and has a minimum premium of $0.20 per contract. If there isn’t an option out there which meets this criteria, then the platform tells you that, and gives the choice of selecting more aggressive POWs.
In summary, writing calls against the stocks you own is an excellent way to generate additional income for your portfolio. And with OptionsPlay Ideas, you can be assured that you’re the writing the perfect covered call, every time.
– Tony Zhang
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