One of those factors, of course, is stock selection. So how do you go about finding the best stocks for covered calls?
What follows are what I consider to be the five most important criteria for call writing stock selection:
Choose high quality companies when looking for the best stocks for covered calls.
I admit that I'm a bit of a broken record about this one, especially when it comes to long term investing, but quality stock selection is also critical when it comes to trading covered calls.
It's so easy to be tempted by juicy premiums on less than ideal companies, but if premium is the only criteria you consider, it won't be long before you really get burned. Covered calls do provide some downside protection, but if the bottom drops out of a stock, you're going to realize just how paltry that protection was.
True, when you sell calls for income, stock ownership is temporary and incidental. But even though you're not a long term investor, ownership is still ownership. And in the short term, even temporary ownership of a mediocre company at just the wrong time, can lead to some serious pain.
The old adage of writing covered calls only on stocks you don't mind owning has a lot of merit to it. If the underlying stock makes a significant move to the downside, you always have the choice of trying some form of rolling out as you wait for the stock to come back. All else being equal, the higher the quality of the company, the more credible that choice becomes.
Technical analysis is probably as much art as it is science, but it's still a critical tool in the search for the best stocks for covered calls. When considering a stock to write calls on, use your favorite stock charting software (or check out the free charts at StockCharts) and consider various short, intermediate, and longer term time frames.
Are you able to see clearly identifiable areas of support and resistance? The easier the chart is to read, the more predictable the stock's price movements are likely to be in the future.
In contrast, a stock is probably not suitable for covered call writing if the share price is erratic, or if it frequently violates major moving averages like the 50-day and the 200-day, or if support and resistance are either unclear or inconsistent.
You can also check out this related article on when the best time to write covered calls is.
Related to the previous points about technical analysis, the best stocks for covered calls will have enough implied volatility to provide attractive premiums without being so volatile that the future share price is essentially unpredictable.
For long term investors in high quality companies, volatility is not risk. For traders (including call writers), volatility is both risk and opportunity.
But it's a fine line. As a net option seller, you get paid to assume someone else's risk. For covered call writers, the risk you assume is stock ownership on someone else's behalf while they retain most, if not all, of the short term potential price appreciation
Just be sure that you don't assume too much risk in order to reach your option income targets.
It's important that the options market on any given stock you're considering as a covered call candidate be sufficiently liquid.
If the options are too illiquid (i.e. very few contracts are traded), your trades will suffer. Not only will the bid-ask spread be too wide for good pricing (whether you're selling a call or buying it back) but if you ever need to adjust or roll a position, the limited number of strike prices and expiration months available will really constrict your choices.
Dividends don't get mentioned much when it comes to covered call writing, except in discussions about whether a call might be exercised early. But you should be aware that dividends do play a role in call option pricing.
In theory, on the day a company pays a dividend, the stock should trade lower by the amount of the dividend because that money is no longer owned or controlled by the company.
For example, let's say that the XYZ Zipper Company paid a $0.50/share dividend on June 1. All else being equal, on June 1st, the company's overall worth should decrease by $0.50/share since that's the amount that just walked out the door.
Obviously, it's the supply and demand of buyers and sellers that ultimately determine the share price, but that dividend payout is still a short term headwind against the stock.
Net result? The premium you receive from selling the call will be reduced roughly by the amount of the dividend for expiration months that include the dividend distribution date.
The takaway is this: the higher the dividend payout, the more of a drag that dividend will be on the premium income you'll receive selling calls. Your best bet for finding the best stocks for covered calls is to limit your selection to those stocks that pay zero or small dividends, or else make sure you time the dividend cycle so that you have no short call positions at distribution.
KO - 125 shares
KMI - 100 shares
BP - 100 shares
MCD - 30 shares
JNJ - 25 shares
GIS - 25 shares
PAYX - 25 shares
Open Market Purchase Price: $20,071.83
Less Booked Option Income: $16,341.71
Tot. Discount: 81.42%
Adj. Div. Yield: 19.59%