Covered Call Investing Strategy

There are a few key measures which must be met in order for me to choose a particular stock/etf for a covered call strategy (those which are Bold are necessary, those which are not make a stock more likely to be chosen but would not exclude a stock either):

1) I first screen all stocks for those which have either a S&P rating of 3,4 or 5, or have a hold, buy or strong buy average analyst rating. This screen is simply to weed out those companies which are not at least considered to be worthy enough to be held by those industry analysts which cover the stock. It is important to keep in mind when using this screen, that often times analysts are wrong. And will often continue to rate a stock as a buy, as it decreases in value, simply continuing to to lower their price targets. By using a covered call strategy, you effectively counter this fact, with a certain level of downside protection.

2) The stock you are looking at needs to have option trading associated with it. Otherwise you will not be able to sell a call on it. Oftentimes smaller cap stocks will not have options, due to the fact that they are simply not followed that well. Additionally, if companies which tend to have low trading volumes do have options, they will often have large bid/ask spreads, which result in some level of uncertainty of your potential return. (bid/ask spreads) will be explained in further posts.

3) Once a stock has met this standard, then I check to see if its current volatility is higher than its corresponding index. Normally for a covered call strategy it is better to find stocks with higher volatility because they tend to have higher time premiums, which essentially means you get a better price for the call option that you sell. However, the reason why stocks tend to have volatility is often because it is unclear whether they will go up or down, which obviously increases risk, however you decrease this risk by selling the call option.

4) Sometimes it is important to consider when a companies earnings release may be, because if it is bad, it could cause the stock to drop by 10 or more percent. However, under current market conditions, stock prices are so depressed, that this metric is not necessarily as important. In times of economic prosperity, this metric would be more important, as a bad earnings report in good economic times, could signal a company is losing its edge.

5) Another key metric to look for is dividend yield, and if the stock will pay a dividend before the next options expiration date. If it does, then you get the added return of the dividend, which both enhances returns, and provides additional downside coverage in case the stock reaches expiration date, and is below the strike price.

Look for further posts to cover how to select a specific stock, at what strike price to sell the option, and for what expiration date once it has met these standards