Best Stocks for Writing Covered Calls

Covered calls are an options strategy allowing investors to generate income from shares they own by selling call options. This article guides readers through identifying suitable stocks for this strategy.

Understanding Covered Calls

A covered call strategy involves owning at least 100 shares of a stock and selling a call option contract. This grants the buyer the right to purchase shares at a predetermined strike price by a specified expiration date, in exchange for a premium.

The premium is the primary benefit. At expiration, if the stock price remains below the strike price, the option usually expires worthless, allowing the seller to keep the premium and shares. If the stock price rises above the strike price, the option may be exercised, selling shares at the strike price, with the premium retained.

Characteristics of Suitable Stocks

Moderate volatility stocks are preferred for covered calls. Low volatility may not generate substantial premiums; high volatility carries greater risk of early assignment or missed upside. A predictable range balances premium generation and share retention.

Adequate liquidity is crucial for the stock and its options contracts. High daily trading volume ensures efficient buying and selling. Options contracts with high open interest and volume indicate a liquid market, allowing easier entry and exit with narrow bid-ask spreads.

Established companies with stable business models and consistent financial performance are suitable. They demonstrate predictable earnings and revenue, contributing to stable stock prices.

Dividend-paying stocks can complement a covered call strategy. Investors receive dividend payments while owning shares, enhancing returns. However, a stock’s price typically decreases by the dividend amount on the ex-dividend date.

Implied volatility (IV) reflects the market’s expectation of future price movements. Higher IV generally leads to higher option premiums. However, elevated IV also suggests greater potential for significant price swings.

Factors to Consider Before Selection

Market sentiment plays a significant role. A bullish market increases the chance of options being exercised, while a bearish market could lead to unrealized losses. A sideways or moderately bullish market is often more conducive.

Company-specific news and events (e.g., earnings, product launches, regulatory decisions) can introduce substantial volatility. These events can cause sudden price movements, potentially leading to a stock being called away or experiencing a sharp decline.

Broader sector trends and economic shifts affect a stock’s suitability. A rapidly growing sector might see highly volatile stocks, while a stable sector offers more predictable movements.

Investment horizon is an important factor. The intended holding period influences the call option’s expiration date. Short-term options offer smaller premiums but allow more frequent collection; longer-term options provide larger premiums but tie up capital longer.

Tax implications are a consideration. Premiums received are generally ordinary income if the option expires unexercised. If exercised and the stock is called away, the premium is typically added to sale proceeds, affecting capital gains or losses. Consult tax professionals for specific tax treatment.

Finding and Evaluating Potential Stocks

Stock screeners are practical tools for identifying potential covered call candidates. Online platforms offer screeners to filter stocks based on desired characteristics like market capitalization, average daily trading volume, or dividend payments.

Analyzing options chains is crucial for evaluating a stock’s suitability. An options chain provides details on available call and put options, including strike prices, expiration dates, volume, and open interest. Reviewing open interest and bid-ask spreads helps assess contract liquidity. Implied volatility indicates potential premium levels.

Staying informed through financial news and reports is important for monitoring company developments and market trends. Reputable sources provide insights into earnings, product developments, and regulatory changes impacting stock prices. Regularly checking financial reports offers a deeper understanding of company health.

Creating a watchlist of potential candidates allows investors to monitor performance and options activity without immediate commitment. This enables observation of how a stock reacts to market conditions and company news, and how its options premiums fluctuate. A watchlist aids informed decisions.