Selecting a Stock for Covered Calls

By: Dan Keen

The following article is an excerpt from Dan Keen's Covered Call Writing: A Low Risk Cash Flow Money Machine

Writing covered calls is a common options strategy. The word write in option market language means to sell. When you have an option covered, it means you own the underlying stock; you are covering your bet. To write a covered call, then, is to sell someone the right to buy a particular stock from you (of which you own shares) at a set price on or before a certain date. You will never know who that someone is if it happens; transactions are all done electronically. But how should you choose your stock to begin with?

First, we must define a set of criteria that we are looking for in a stock to fit our covered call formula. The criteria:

1. The stock must be optionable. The stock must be one that trades on the options exchanges. Not all stocks are optionable. To find out if a stock if optionable, look in the stock tables of a financial newspaper. The Wall Street Journal has a section listing optionable stocks. Investor's Business Daily prints an "o" designation next to every stock that is optionable. Another way to use the Internet and is to go to The Chicago Board Options Exchange (www.cboe.com), click on "Delayed Quotes" and enter the stock's ticker symbol. If the stock is optionable, the screen will display a list of prices and dates for options contracts.
2. The stock must be affordable. Since options contracts are written in 100 share increments, you must own at least 100 shares of the stock. We suggest you have a minimum of $1,500 to $2,000 available in your brokerage account to get started. The stocks we want to look at, then, must have a current price between $5 and $20 a share. This is a more comfortable price range, and one in which there are many good quality stocks.
3. You must be neutral to slightly bullish on the stock over the next few months. You don't want to pick a stock that will go down during the period before the expiration date. You also don't want to pick a stock whose price will increase dramatically, because writing a covered call limits you upside potential. If you purchased a stock at $14 and you write a covered call with a strike price of $15, you are selling the right to have someone buy the stock from you at $15. Sure, you made $100 on the sale and you also made money by writing the covered call option (maybe another $10 or $100). But, if you had simply purchased the stock and sold it, you would have made even more money.
4. The play must generate a decent return on your investment. The premium ("bid" price) being paid for writing a covered call at the next higher strike price with an expiration date of no more than one or two months away, must be enough to make the trade profitable and worth the risk. Our basic plan is to select a stick price that is the next closest price above the current stock price, with an expiration date of only one or two months in the future.