When you sell a covered call, you treat your stock as a rental property. Here are the qualities you seek in an equity position that you would like to rent:
- Priced under $8.00 per share – under $5.00 per share is best.
- Options chain is available.
- Price is likely to go down by the contract’s due date.
- You would not have seller’s regret if the contract is executed.
- You have done your mental math before you buy: P@ = S.P. + B.P, and Pc / (Pc – P@) > 25.
The symbols in the two equations above are:
P@ = At-the-money price
S.P. = Strike price
B.P. = Bid price
Pc = Current price
The five criteria, once again, are:
The stock is affordable for you. I don’t like to spend that much on the initial purchase of a stock. Since you can only rent stock in lots of one hundred shares, the per share price has to be low. If the price per share is $5.00, you must spend $500 to acquire the property. If you have to spend $800 to acquire an attractive property, so be it.
A market for covered calls exists. The stock will not have an options chain if you cannot buy and sell options for that symbol.
The outlook for the stock over the next one to six months is weak. A covered call is a conservative way to short a stock. You don’t want to sell a covered call for a stock that you expect will increase in value. Exception: you might sell a covered call for a stock that you hope will appreciate. In that case, the options contract is a hedge against depreciation.
You don’t care to hold the stock over the long term. During my initial experiments, I sold 500 shares of Resource Capital Corporation (RSO). I had taken a long time to build up a good position in that company, since it pays a good dividend. I regretted the loss of those shares in my portfolio.
The at-the-money price is not too far below the current price. The difference between the current price and the at-the-money price should be less than 4% of the current price. That’s the significance of the equation, Pc / (Pc – P@) > 25. Your desired outcome is that you keep the rental income and the stock when the contract comes due. If the stock price has to fall more than four percent over the life of the contract for that to happen, that’s not a contract you want to sell.
That’s it! It sounds a little complicated, but I learned these things over a fairly short period of time. Now I see renting stock as an entertainment enterprise. People who buy covered calls are likely to be gambling investors rather than value investors. They bet that the price of a stock will increase, but they want to place the bet without shelling out for a full one hundred shares. Rather, they want to pay a premium that gives them the right to buy the stock sometime before the contract comes due. If the stock appreciates enough, they make money on the contract when they resell the stock. If the stock price goes down, they don’t buy the stock and they lose their premium.
The bet is entertaining on both sides, but the bet is asymmetrical. That is, the buyer of the contract stands to lose more than the seller. The exception is if I have to sell stock that I bought some time ago for a substantially higher price. You might want to sell the stock in any case, but often you would want to hold it for quite a while to see if its value goes back up. Sell a call on a stock that has depreciated since you bought it only if you are interested in selling the stock anyway.