When Is The Best Time To Write Covered Calls?

Determining the best time to write covered calls is an important question and issue. Writing calls against shares of stock you own can be a good conservative option strategy, but there are still risks to both the upside and downside, so choosing the opportune time to write your calls is crucial.

The most obvious answer to the question is that the ideal time for writing calls is when the stock is moving higher (or at least not moving lower).

Still, not all covered call writers have the same objectives, so it may be helpful to examine a few different scenarios and see if we can gain any additional insights.

Here then are three different scenarios . . .

Generating Income On Your Long Term Holdings

Selling calls in order to generate additional income on your long term holdings (where you don't want to be assigned or forced to sell your shares) can be an incredible way to boost your long term returns.

The trick is to generate premium income without having the calls go in the money (i.e. the shares trading above the strike price at which you've agreed to sell your shares) and putting you at risk of losing the stock.

I actually cover this issue and how to help protect yourself from big moves higher in the underlying stock thoroughly in The Essential Leveraged Investing Guide.

Regarding the specific timing of those type of trades, the best time to write covered calls would be when the stock is falling (and when you believe it will continue falling).

Say what?

Why would you hold on to a stock that you thought would be falling? Again, we're talking about a scenario in which an investor has long term holdings and DOESN'T want to sell.

True long term investors consider themselves owners of businesses, not owners of stock certificates. It wouldn't make sense for them to dump a company they've owned for perhaps decades (and built up huge effective dividend yields on) just because the shares are experiencing normal price fluctuations (in technical terms, these fluctuations are alternatively known as either a "zig" or a "zag").

Additionally, there might be major tax consequences related to capital gains (even at long term rates) that would ensue if they sold their shares.

Conservative Income Generation

You don't have to be a conservative long term investor to set up conservative convered call trades. In fact, one of the attractions of writing covered calls is that they can be set up to be so conservative.

Aside from choosing a healthy and profitable (and not overvalued) underlying business on which to write calls in the first place, the other factor that goes into setting up a lower risk covered call trade is the strike price you choose.

Writing in the money calls (at levels below the current share price) is the safer way to go, at least in terms of downside protection since the stock would have to fall below the strike price in order for you to NOT be assigned (you would want to be assigned with this approach).

Remember, an actual assignment equals a profitable trade.

So when is the best time to write covered calls in the money?

Ideally, to make the trade even more conservative (i.e. safer), the ideal time is when the stock is (or when you believe the stock will be) moving higher.

Again, this certainly won't be the way to maximize your total potential covered call returns, but if you're already selecting a conservative income-oriented trade (writing covered calls in the money), why would you undercut yourself by increasing the risk on the trade by writing calls on a falling stock?

Writing Covered Calls for Income and Price Appreciation

If you're comfortable with more risk, you can increase your potential returns on a covered call trade by writing your calls out of the money (See "Rule of Thumb" in the blue callout box above).

Out of the money calls will give you less premium than calls written at the money, but the higher strike price allows you to participate in more of a stock's run (up to the strike price at which you wrote the call).

Again, this is a more aggressive approach because it gives you virtually no downside protection, but whenever you're convinced that a stock will be moving higher from that point on would be the best time to write covered calls out of the money.

There is a bit of a balancing act involved, however. Write your calls too far out of the money, and the premium levels might not be worth it. Don't write them far enough out, and the stock could blow past your strike price and force you to leave a lot of potential capital gains on the table.

Conclusion

For the conservative and judicious income investor, covered calls can be a solid low-risk strategy than still provides some pretty decent returns.

They're not necessarily suited for all markets and all stocks, however.

Volatile markets (and stocks) where there are big moves, either higher or lower, can wreak havoc on your portfolio (you end up leaving too much money on the table when the underlying makes a big move higher and you don't get enough protection when the underlying makes a big move lower).

My preference, as I've already alluded to, is to use them in conjunction with my long term portfolio. I'm biased, of course, but I find that this combined long term quality stock investing and conservative option trading approach is ridiculously effective and ridiculously profitable.

I just wish someone would invent a time machine so I could go pay myself a visit 20 years ago and teach myself this stuff.

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