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How to Write Covered Call Options – A Step by Step Guide


We had an article here in the past that explained the basics of how call option writing works, but we never got into the mechanical details.  As the reader questions continue to pile up and the markets becoming more volatile, the question of how to write a covered call option with a discount brokerage account is becoming more common.

I’ll be honest in admitting that I’ve only written a few covered call options, mostly for experimentation purposes.  Even though I’m not an expert options trader, I can explain the details on how to write a covered call with a regular discount brokerage account.

Before we get started, lets explain what exactly a covered call option is.  As options are a fairly advanced investment strategy, they should not be taken lightly.  A covered call option is when you own the underlying security, and you sell the option for another investor to purchase at a specified price.  The call option buyer pays the seller/writer a premium for the option to purchase the stock in the future.  If I were to use the casino analogy, the call option “seller” would be the house as most options are never called away.

How to Write a Covered Call Option

As the last couple option trades that I made were with Questrade, I’ll step through the process with their interface.  Although this description may be specific to Questrade, it should be very similar to other interfaces (at least it is with CIBC and iTrade).

Pick a Security to Option

Lets assume that you have an equity that you are willing to write a call option against.  Ideally, it’s an equity that you’d sell at the strike price anyways and not fret if it gets called away.  For example, in this case lets assume that you own at least 100 shares of Suncor (SU), and it’s getting close to the price you’d like to sell it anyways.  As one option contract equals 100 shares, you’d be able to write one covered call on Suncor.

Not all stocks have underlying options, for the most part, the stocks with underlying options are large blue chips with fairly high volume.

Order Entry

To start, you’ll want to go to the “options” portion of your interface.  With Questrader Web, it’s the “Trading Centre” tab -> “Options”.  From there, you’ll see this form on the right side:

optionsmenu

If you’ve made any trades before, the form above shouldn’t be too intimidating.  Here’s an article on how to read traditional stock quotes which includes bid/ask explanations.

Symbol: The symbol is straight forward, which is simply the stock symbol for the underlying stock that you want to trade options with.

In this example, I used Suncor which is traded on the TSX.  From there, click the magnifying glass to get the options quote and options symbol which brings up the table below.  Simply click the “trade” link for the option that you want to trade and it will automatically populate the order entry field.  Read further down for details on how to decipher this table.

optionsquote

Reading the table: Options expire every third Friday of the month, which is the contract date above.  In this example, I chose the June expiry which displays corresponding quotes for each option available.   Referring to the table, everything above the $38.57 shaded line is “in the money” while everything below is “out of the money”.  The more “in the money” the trade, the higher the premium that option seller will receive.  The further the strike price is “out of the money”, the lower the premium but the less likely the option will be called away.

If I choose a $40 strike price, this means I’m willing to sell my Suncor stocks for $40 providing that the option buyer pays me a premium of $90 (ask price x 100) per option contract.  If Suncor closes higher than $40 on June 18th, it is likely that my position will get “exercised” thus called away. At that point, it’ll be the same as if I sold 100 shares for $40 plus whatever I collected as a premium.  However, if the stock closes lower than the strike price, then the option will simply expire and I get to keep my shares (and the premium!).  At that point, I’ll likely rinse, repeat and continue collecting premiums.

#Contracts: One contract equals 100 shares of the underlying stock.  So if you own 200 shares of Suncor, but you only want to write an option against 100 shares, then put 1 in this field.

Limit Price/Order Type: I personally always use limit orders to prevent surprises when buying or selling.  You can see from the table above what the bid/ask prices are for each option.  Note that the bid is what the buyer is willing to pay, while the ask is what the seller is willing to sell for.  Both prices will likely fluctuate so it’s best to set your price close to the going rate and let it happen.  Stops are typically used to automatically sell a position should it fall to a pre-determined price.

Transaction: This is where some investors can get confused.  For call option writing, the option to choose is “Sell to Open“.  This simply means that you are selling the option to open the position.  If you want to buy back the option that you sold, or buy any option “long”,  you choose “buy to close”.

Duration:  This is the duration that the order will remain open if not executed immediately. Day will keep the order open until the end of the trading day and Good Till Canceled (GTC) will remain open until manually canceled.

Preferred ECN:  Most of the bank brokerages do not allow ECN to be chosen. Even if they do, I always leave it on auto. Brokerages like Interactive Brokers will charge extra if the Auto/Smart ECN routing isn’t selected.

AON:  This stands for All or None, which means if you can’t trade the number of shares/contracts that you indicate, the trade will not execute.

This concludes the very basics of selling/writing call options with an online stock broker.   If you have any questions, or anything to add, please leave them in the comments.

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FrugalTrader About the author: FrugalTrader is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 46 comments… add one }

  • Brandon May 16, 2011, 10:07 am

    Awesome post. Funny because I was searching for this EXACT same thing last week. Figured it out on my own…

  • Dutchie May 16, 2011, 10:12 am

    Very good explanation for cover calls. I’d be interested in reading one for Naked puts with Questrade aswell.
    Thanks.

  • Echo May 16, 2011, 12:38 pm

    Nice step-by-step guide FT! I’ve never written a covered call option before.

    One thing to note is that you will need to disclose to your discount brokerage that you want to start writing options, since the “ordering options” feature should be disabled when you initially set-up your account.

  • cannon_fodder May 16, 2011, 1:16 pm

    I’d be interested to hear what those who engage in this practice for blue chip TSX listed stocks expect to achieve on an annual basis percentage wise. I will do this but use strike prices that are very unlikely to be hit because I don’t want the capital gains tax when I’m at the highest level.

  • sco May 16, 2011, 6:50 pm

    I use this strategy in my QT rrsp account, to reduce volatility and increase the return. They charge too much ($10/ trade + $1/contract), so it can’t be properly used with deep out-of-money strikes (where the contract brings in pennies). Due to the high transaction costs, even selling ATM strikes won’t increase the return too much. I got about 2% extra last year with a US ETF. The real advantage is reduced volatility.
    Beware of options with reduced liquidity (like most Canadian ones). The spread will probably eat any potential gains.

  • The Dividend Ninja May 16, 2011, 8:10 pm

    Thanks for providing information on the details of the Covered Call Option, this is somehting I will be looking into in the future :) So is there a minimum amount you would need to trade i.e. 100 shares to make this trade worthwhile?

    Cheers
    The Dividned Ninja

  • FrugalTrader FrugalTrader May 16, 2011, 11:13 pm

    @Canon, I believe it’s all in the volatility of the stock, and the probability that the strike price will be met. There are tools on the net that can help with that.

    @dividend ninja, yes, you need a minimum of 100 shares of the underlying stock in order to sell a covered call.

  • FrugalTrader FrugalTrader May 17, 2011, 1:02 pm

    ZWB (BMO ETF) is a covered call ETF that holds the big banks and sells out of the money covered calls and it yields over 9.5%.

  • Ed Rempel May 17, 2011, 8:19 pm

    Hi FT,

    Interesting article. Do you use covered calls? Have you found them to be useful?

    I know about them from a text book view and from talking with our fund managers. I am under the impression that covered calls are like stop losses – a strategy marketed to DIYers to create more transaction fees, but not really used by professional investors.

    The strategy sounds good on paper, but we only know a handful of professional investors that use covered calls and almost none that use stop losses.

    I took an in-depth hedge fund course where they taught that any option strategy involves getting something and losing something. It is always important to understand what you gain and what you lose.

    With covered calls, you gain a premium and lose the opportunity for significant gains. You still have 100% of the downside risk, but your gain is limited.

    This may sound like a reasonable tradeoff, except that large gains are much more common than most people think. The stock market generally has a gain over 20% in 25-30% of years. Unexpected gains would be even more likely in shorter periods and with specific stocks.

    If you eliminate large gains from your long term returns, then your long term average return will be far lower. The stock market without the 20+% years would probably average 7-8%/year lower. This difference will probably be far more than the premiums you collect.

    Personally, I would rather participate fully in the long term growth of my investments than collect some small premiums.

    Ed

  • FrugalTrader FrugalTrader May 17, 2011, 10:57 pm

    Hi Ed! I have played around with them. I basically choose calls that have a low probability of being called away. I’ve been called away once which was my first call, but haven’t been called away the last 4 times.

    However, after doing some reading, a much easier method of getting covered call premiums is simply buying an ETF that does the work for you. ZWB and HEX.

    That just gave me an idea for a post! :)

  • Chris May 18, 2011, 8:44 am

    @FT: I believe that your description of “in the money/out of the money” is not quite accurate.

    “Everything above the current price of $38.57 is “in the money” while everything below is “out of the money”. The more “in the money” the trade, the higher the premium that option seller will receive. The further the strike price is “out of the money”, the lower the premium but the less likely the option will be called away.”

    I believe it should say below the current price is in the money and above the current price is out of the money. This is reversed when you’re looking at Puts options.

    For those who are seriously interested in option trading, there are some free resources (videos) online through the montreal stock exchange website and the scotiaitrade website.

  • Chris May 18, 2011, 8:59 am

    The re-edit timed out on me….

    A couple of things about options:

    1) Options are traded in units of 100 shares. So when you buy or sell 2 options, you are asking to control 200 shares of the underlying security.
    2) For those of us who invest in our RRSP/TFSA accounts, put options are not allowed nor are naked call options.
    3) When doing covered calls, if your call gets called away, the bank will automatically sell the security to the call option owner for the strike price.
    4) Ideally, for covered call writers, the stock price will stay roughly below the strike price.

  • FrugalTrader May 18, 2011, 8:59 am

    @chris, thanks for the heads up. I was actually referring to the table when indicating “above” and “below” but I can see how that is confusing. I will modify the post.

  • jan May 18, 2011, 1:50 pm

    Good article. I have used covered call writing for 25 years and it works very well for me. Your readers should be aware of the pitfalls of the strategy. The biggest is that your portfolio over time becomes biased toward under-performing stocks. If you buy 10 stocks, 3 may go down and you keep them, but you can not profitably write calls at the same strike, 3 go up and are called away, 4 stay where they are and you write new calls. In the next cycle a similar weeding out of the best stocks happen and in the long run you are left with a lot of dogs. The technique works best for stocks that are very stable. TA POW PWF MIC are examples.

  • Dhruv Chhabra May 18, 2011, 3:59 pm

    Hi FT,

    Thanks for this article. I have a dummy account with Questrade. I have bought a couple of stocks ranging from Rio Tinto and BHP to GM, Google and Coke.

    I wrote call options for BHP, RIO and GM. I selected the options and used limit price at advised by you.

    All 3 of them were executed. So executed means that the buyer has bought my call option? Is that what “EXECUTED” means?

    If that is the case and I have made a premium on all 3 of them, how does Questrade receive its $11 (per call) commission on this transaction?

    Thanks for your help.
    Cheers,
    Dhruv

  • FrugalTrader FrugalTrader May 18, 2011, 9:00 pm

    @Dhruv, executed means that your order went through. So say that with BHP, the premium was $1 per contract and you wrote a covered call for 1 contract. You would have received a premium of $100 minus the commissions owed to Questrade.

  • Chris May 19, 2011, 1:57 am

    @Dhruv,

    Just remember that when you make a premium, the cost for that premium is the risk that you take holding onto that stock for a specified period of time … (especially with covered calls).

    For me personally, whenever I do covered calls, I make sure that I am willing to keep that particular position for the specified length of time. Otherwise, if you have to buy yourself out of that contract, it will ALWAYS cost more.

  • Walter May 19, 2011, 10:30 am

    @ED – “I know about them from a text book view and from talking with our fund managers. I am under the impression that covered calls are like stop losses – a strategy marketed to DIYers to create more transaction fees, but not really used by professional investors.”

    Sorry Ed most fund managers aren’t allowed to use options as its against the rules.
    Only a select type of funds are allowed to use options and NO it wasn’t created for DIYers or to create fees.
    Like me and most of the professional money managers that I know use them. Its no surprise that someone would write something where they know nothing about the topic and claiming thta the buy and hold works, sorry it does any stock is able to rise or fall by 20% on any given time frame.

  • Dhruv Chhabra May 19, 2011, 3:51 pm

    Thank you FT and Chris for this input.

    @ Chris: I plan to keep the contract for the specified time period. I generally sell covered call contracts for a 4-5 month period. Is that a good enough time?

    I have noticed another thing. The longer the time period of your contract, the greater the premium you receive per share.For a 1 month covered call contract, BHP was paying around $1 per share, while for a 6 month contract they were offering $7.50 per share. That’s a huge increase per share.
    What might be the case?

  • kansai_92 May 19, 2011, 8:20 pm

    I don’t understand Questrade’s terminology.
    How do you sell a put option?
    Which type do you select in the drop down?

  • Walter May 20, 2011, 4:37 pm

    kansai_92 all brokers use the same terminology. If your “writing a put” the pull down screen would need to be “sell to open”, since I don’t use “Questrade” it would ask you is it is covered, were you would need to use a pull down screen “uncovered”
    If its a RRSP or a TFSA don’t bother as you cannot trade a naked put.

  • Walter May 20, 2011, 4:45 pm

    The re-edit timed out on me….

    A couple of things about options:

    1) Options are traded in units of 100 shares. So when you buy or sell 2 options, you are asking to control 200 shares of the underlying security.
    2) For those of us who invest in our RRSP/TFSA accounts, put options are not allowed nor are naked call options.
    3) When doing covered calls, if your call gets called away, the bank will automatically sell the security to the call option owner for the strike price.
    4) Ideally, for covered call writers, the stock price will stay roughly below the strike price.

    @Chris, #2 isn’t correct, you can buy puts in your RRSP and TFSA’s, Just not sell them (as in naked puts).
    #3 isn’t correct either, the clearinghouse will notify the broker that a share swap for the cash amount minus commish.
    #4 it depands on what you want to do. I find the best is that the stock gets called.

  • Ed Rempel May 24, 2011, 12:49 am

    Hi Walter,

    Are you actually a fund manager? Nearly every mutual fund is allowed to use options or other derivatives. Read their prospectus.

    For example, here is a typical quote from a mutual fund prospectus:

    “Mutual funds may use derivatives to protect against losses from changes in stock prices, exchange rates or market indexes. This practice is known as hedging. Mutual funds may also use derivatives to make indirect investments or to generate income.”

    “Generate income” would be selling covered options, which is just one of the options strategies allowed in most mutual funds.

    Not very many fund managers I know of use this strategy, though. Giving up your chance of making large gains can often reduce your long term return.

    The reason you can sell an “out of the money” call option and still get a premium is that someone else is betting that amount of money that a large stock move will get the stock above that point.

    Most options do expire worthless, but experience fund managers know that these large, unexpected surges in stock prices happen much more often than you may think.

    Consider Nassim Taleb, the author of “The Black Swan”. His company bought the options of thousands of companies that were far “out of the money”. They made a lot of money buying these options because they found that the “1-in-10,000″ huge stock gains actually happened “1-in-1,000″ times – or about 10 times more often than sellers of options believed.

    Ed

  • Walter May 24, 2011, 6:25 am

    Hi Ed

    Yes Ed I am a private money manager in London and yes I use options and futures for my client.
    I don’t know where you cut and pasted that quote from re: mutual funds may use derivatives. Please list the fund or link the prospectus?

    Does this “fund” list that they will use derivatives in their investment objectives?
    if not and they use them they are breaking the law.

    under “Investment Strategies”
    what you don’t see is the investment restrictions of funds as that is a back office rule and decision making process with the full eye on the regs.
    My point being if the Mutual funds (not hedge funds) these funds would have had A) a stop loss on their investments or B) had bought puts as you had suggested and that would have made them have a far better return in 07-09 or on any down market.

    So to correct you again most Mutual funds do not write cover calls or use derivatives, as most are restricted on using options and futures, for a number of reasons. unless its written in their Investment Objectives.

  • FrugalTrader FrugalTrader May 24, 2011, 9:11 am

    @Walter, what are your thoughts on ZWB and HEX? I wrote an article about them here: http://www.milliondollarjourney.com/covered-call-etfs-hex-and-zwb.htm

  • Walter May 24, 2011, 10:48 am

    @ FrugalTrader.

    Well the first thing that is an issue is that they are both too new, second ZWB has an issue as its not following its own guildlines, its holding 50.3% of its self in this fund.. Have a look at PIC.A on the toronto exchange, this one doesn’t have 50% of its self invested into it self. To me it looks like that it’ll start paying out its capital as 50% of the investment is not option writeable. Lets look at the numbers. 50% is off the table from writing cover calls. So that it leaves 50% to generate 9% and about 3% of that is from dividends collected. A quick look at their written calls they are at the money, so little to no capital increase. Using some logic is it fair to assume that this fund is able to collect 9% from half its assets? in reality it would be like trying to collect 18% every year. Its possible but, not likely to happen. What we don’t know is, what is the price points for entry and exit. Buying back a position after it gets called away at a higher price doesn’t work it never has. Unless they are writing puts to buy back their position at their fundamental price point.

    .

  • FrugalTrader FrugalTrader May 24, 2011, 2:34 pm

    @Walter, thanks for the feedback. So would you say that HEX might provide an advantage over ZWB since it can write options against all of their holdings? How likely is it that it can sustain a 15% yield based on dividend + premiums without ROC?

  • Walter May 24, 2011, 6:20 pm

    I would say that HEX has a better advantage. However you must be aware that I don’t know if they’ll chase a stock as it gets called away. If they chase stocks that are running it would place a higher risk amount on the rewards.

    If you like a could explain a simple method of writing a covered call?

  • FrugalTrader May 24, 2011, 8:05 pm

    @Walter, I would love to see your covered call writing strategies!

  • Chris May 25, 2011, 2:42 am

    @Walter thanks for clearing up for me
    Re 3 as a new DIYer as far as I see it, when the strike price is reached and you’ve been selected , your share gets sold automatically. My only point was I remembered my first time that I wasn’t sure if I had to physically call/email someone to finish the transaction

  • Walter May 26, 2011, 5:30 am

    @Chris, to answer your point..No you don’t need to do anything, however you can (depends on your broker) notify them that you’ll close the position so that its not excerised.

  • Walter May 26, 2011, 5:42 am

    @FrugalTrader, sure… the simplest cover call strategie, that I use. in short form

    1) know your fundementals of the company that your buying/own.
    1a) fundementals sets your buy price.
    2) know what your sale price for that stock is.
    3) check the technicals, before your place your order.
    4) know when the company is releasing its earning reports, and when they go ex dividends.
    5) Have an understanding what your risking in return for what?
    6) place your order at your price. If you want $1.10 per share palce your order at the price.
    6a) sell your call on a positive day vs a negitive one.
    7) and this is important when #1 and 4 changes so does #2

    Its as short and sweet as I can make it
    an example to follow.

  • Walter May 26, 2011, 6:29 am

    example. we’ll use the Royal Bank and using point 1), 1a) and 3) on the list above.

    buy one hundred shares of RY (yesterdays close price) and lets say you have it into your TFSA so no taxes to worry about.

    100, RY @ 59.83 = 5983 plus commish.

    Looking at the option list on the Montreal exchange and knowing that commish is a big factor with 1 contract.
    So I’d be looking further out so it’ll eitherbe the Oct 62 or the Oct 64. So lets go with the Oct 62 contract.
    1, RY, C OCT@ 62 for $1.40 I’d push it a bit as its trading around $1.35
    netting $140 minus commish (note: watch the commish as it’ll cost you for both sides if called away)

    The returns.
    you collect $140 or 2.34% up front (reguardless of where the stock price is)
    you’ll collect the $50.00 dividend in August/September (its rare for a stock to be called away half way through the contract time, but it can happen)

    If RY closes @ $62 or less in OCT:
    The lowest return is 1.40 + .50 = 1.90 for 5 months 3.18%, annualized 7.62%

    If RY closes over $62 in OC:.
    The best out come would be the price difference 62-59.83 = 2.17 + 1.4 + .50 = $4.07
    so the best on this trade (as it gets called away) 6.8% for 5 months, Annualized at 16.32%

    Since everyone has different Commish costs and a different number of contracts it would mak eit difficult to calculate it. So I have not deducted the amounts for it on the returns.

  • Maritimer November 18, 2011, 12:27 pm

    How are the option premiums handled for tax purposes?

  • FrugalTrader FrugalTrader November 18, 2011, 12:39 pm

    @Maritimer, my understanding is that premiums collected are treated as capital gains.

  • Walter November 18, 2011, 7:01 pm

    FT – pretty good guess. I have included a link to the montreal exchange about how canadians are taxed on options:

    http://www.m-x.ca/f_publications_en/brochure_fiscalite_kpmg_en.pdf

  • cmsdge July 15, 2012, 7:09 pm

    I am trying to write covered calls with Questrade, but I seem to be missing something. The transaction is being refused b/c I don’t have enough “buying power”. Here’s what I did:

    1. Buy 1000 shares of company X using cash (no margin) in TFSA.
    2. Write covered call for 10 option units (sell to open).

    It seems to be something about a margin requirement on the ‘short’ options position #2 would create. Does anybody know what the requirement here is? Since it is a covered call, i’m surprised there is a margin requirement.

    Thanks if anyone can help!

  • maritimer July 15, 2012, 8:20 pm

    @cmsdge Did you wait for thé Trade to settle. This is 3 business date after Trade was made, which is when you actually own thé shares. I suggest you call questrade for sure. I believe I am correct

    In a margin account, you likely don’t have to wait.

  • Walter July 15, 2012, 9:46 pm

    maritimer is correct, the time before it shows up in your account and the time you try to sell an open call is most likely the issue. You could call your broker and place your option trade as they’ll see that you have in fact bought your position. Make sure that you get your trading fee at the same rate as if you did it online.

  • cmsdge July 16, 2012, 12:43 pm

    Thanks guys, tried again this morning and it worked, I didn’t realize there was a 3-day wait for trades to settle! :)

  • Walter July 16, 2012, 3:16 pm

    Didn’t know that there is a 3 day to settle….eyes roll

  • Jason September 5, 2012, 1:50 pm

    Maybe I’m just missing it.. But are these posts and comments not dated?

  • Walter September 5, 2012, 3:15 pm

    Hi Jason, yes there is no date stamp. This discussion is months old but, the info is still relevent thou.

  • bt January 21, 2015, 1:17 am

    quick question on writing covered calls.
    i am using td and i have the underlying in a non-registered account (separate from my margin account)

    if i want to write a covered call in my margin account and the option does get called away, will tdwaterhouse know to settle the stock in my other account OR do i have to have the underlying stock purchased/residing inside the same margin account?

    thanks in advance.

    • FrugalTrader FrugalTrader January 21, 2015, 10:38 am

      @BT, so you have two non-registered accounts? One cash and one margin? Typically, there is one non-reg account for each currency, which has the margin attached to it. For me, when I write a covered call and it expires worthless, then it disappears from my account after a number of trading days. If it’s in-the-money and gets exercised, then the corresponding shares will get sold from your account.

  • Walter January 21, 2015, 3:03 pm

    bt, TD would NOT know to settle in another account. Just think of it in the simplest form. Each account is separate, if what you’re suggesting applied folks would write cash covered puts for their RRSP accounts. What a field day that would turn into.

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