Covered calls have become one of the most widely used option strategies for generating income. While simpler than most option strategies, finding the right covered call opportunities can be challenging—especially when you’re trying to build a holistic portfolio with minimal risk.
In this article, we will look at how to choose the right stocks and calculate the potential returns for covered calls, as well as take a look at various tools that can speed up and improve the process.
What Stocks Should You Choose?
Most investors focus on large-cap, blue-chip, dividend-paying stocks that have predictable volatility when writing covered calls. In general, you should be comfortable owning the underlying stock for a long period of time—even if the stock price declines during the covered call time period.
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We screen for stocks using a few different criteria in the Snider Investment Method:
- SIM Score: Our proprietary SIM Score measures price volatility over a multi-year period to filter out the most volatile stocks from our list of covered call candidates.
- RapidRatings: RapidRatings is an objective methodology for quantifying bankruptcy and/or solvency risk based on various inputs from financial statements.
- Diversification: We apply asset allocation rules to limit exposure to any specific sector, industry, and individual company. That way, the entire portfolio doesn’t suffer from any single decline.
In addition, you should consider any factors that could influence a stock’s price over short periods of time. The most common cause of short-term volatility is an earnings report, but you should also watch for industry events, analyst meetings, regulatory risks and other factors.
Take our free Stock Selection 101 educational course to learn the fundamentals of proper stock selection techniques.
What Options Should You Choose?
The next step is choosing the call options that you’d like to write against a given underlying stock. In short, most investors choose monthly call options that are slightly out-of-the-money, but you may choose other options based on your individual investment objectives and risk tolerance.
The two key factors to consider are:
- Expiration Month: An option’s value decays faster in the final 30 days of its life, which means that most investors stick to monthly call options rather than longer-term options. It’s also important to consider months that the underlying stock has earnings reports or other unpredictable events that could have an impact on the price.
- Strike Price: You should consider in-the-money options when you think the stock price will decline, at-the-money options when you think the price will remain even, or out-of-the-money options if you think the price will appreciate. Often times, conservative investors use in-the-money options because of their greater downside protection.
Calculating Potential Returns
The final step is calculating the profit potential for options you’re considering to select the best opportunity.
Most investors calculate both *flat* and *if called* returns for their covered call positions. These returns are the same when the covered call is in-the-money or at-the-money, but out-of-the-money if called returns are higher by the amount that the call option is out-of-the-money.
Let’s take a look at how to calculate each of these returns, as well as annualize the returns to make fair comparisons.
Flat Return
The flat return assumes that the stock price remains the same through expiration.
You can calculate the flat return in three steps:
- Determine the time value.
Time Value = Premium – Intrinsic Value - Determine the net debit.
Net Debit = Stock Price – Call Premium - Determine flat return.
Flat Return = Time Value Premium / Net Debit
If Called Return
The if called return assumes that the option is exercised, even if it’s out-of-the-money.
You can calculate the if called return in three steps:
- Determine the time value.
Time Value = Premium – Intrinsic Value - Determine the net debit.
Net Debit = Stock Price – Call Premium - Determine the if called return, including profit.
If Called Return = (Time Value Premium + Profit on Exercise) / Net Debit
Annualizing Returns
Annualizing returns can help you compare multiple covered call positions with different days until expiration. After all, a six percent return with many days to expiration may be far less desirable than a two percent return with fewer days to expiration—annualized numbers are what matters.
Start by calculating the non-annualized returns and the holding period in days. You can use the following formula to annualize the return:
Annualized Return = Static Return / Holding Period * 365
You should always look at annualized flat and if called returns when comparing the profit potential for covered call opportunities.
Screening for Opportunities
The process of screening for stocks and calculating the profit potential for each call option using option chains on the CBOE’s website would take days or weeks. By the time you found the right call option, you would have already missed the opportunity and would have to go back to the drawing board.
The good news is that there are many different tools that can help you automatically identify potential covered call opportunities.
Covered Call Screener
Snider Advisors offers a free covered call screener that sorts through market data to produce the covered call combination of owning shares of stock and selling a call. After selecting an expiration date, stock price range and other factors, the screener returns a list of opportunities that includes key metrics like the if-called return and downside protection.
The free covered call screener implements the first layer of our comprehensive stock screening, record-keeping and portfolio management software, Lattco. The full version of Lattco is available exclusively for graduates of the Snider Investment Method course.
Proprietary Software
There are several proprietary software solutions designed to screen for covered call opportunities. While many platforms provide similar features to broker research tools, Snider Advisors takes a comprehensive approach with a complete portfolio management strategy centered on generating income with covered call positions.
For those that don’t have the time to manage their own portfolio, we also offer full service asset management. We monitor client portfolios on a daily basis to identify opportunities to sell covered calls and generate a return as close to one percent per month as possible.
Download the Snider Investment Method Owner’s Manual to learn more about our strategy and how you can use it to generate an income using covered call positions.
The Bottom Line
Covered calls are a great way to generate an income from a portfolio of stocks. Rather than haphazardly selecting options based purely on return, you should build a comprehensive strategy that factors in both risk and return. You can then ensure consistent income over time.
If you’re interested in learning more, sign up for our free course on Covered Call Stock Selection and learn how the Snider Investment Method can help you succeed with covered calls.
