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Finding The Best Stocks For Writing Covered Calls
My thought process for steady profits.
Covered calls can be an extremely powerful tool for cash flow in normal times (anyone still remember those?) when markets don’t keep returning double digits while the world burns.
I personally use them to roughly double my dividend payouts, and turn the cash flow into even more shares of businesses I believe in.
I’m not a financial professional. This is purely opinion and entertainment, not advice. Do what’s right for you, and if in doubt about what that is, then it’s important to find someone who’s legally able to tell you.
The strategy itself is beautifully simple, and I’ve covered it here at length:
I’ve also shared some caveats you should consider before building your financial plans around this strategy:
But this leaves one critical question open: how do you find the best stocks for writing covered calls?
If you’re using covered calls for ongoing cash flow, then choose stocks you genuinely want to own, including non-trendy blue chips and reliable dividend payers. If you’re trying to maximize premium in the short term, then look for trendy companies in the middle of significant growth, but remember that the risks of capital loss and opportunity cost are far higher.
I like to treat covered calls the same as my dividend portfolio:
- Start by getting ideas from a list of Dividend Contenders/Champions/Aristocrats/Kings.
- Screen for acceptable P/E ratios.
- Look at free cash flow and EPS growth.
- Think about moats and pricing power.
- Buy it if everything checks out and 100 shares wouldn’t consume too much capital.
In other words, nothing special!
Sometimes you can find a happy medium by choosing large, established firms in a suddenly hot sector. Big pharma, home improvement, and traditional autos (to some extent) were all great examples in 2021. All the usual screening criteria still apply, but the trendiness may correspond with higher implied volatility (IV) and therefore higher premiums on fundamentally sound businesses.
This is not exciting, and probably not the clear-cut formula or “hot picks” you might have hoped for, but it’s the low-stress way to choose positions that you don’t lose sleep over.
Picking covered call stocks: two schools of thought
There are two main approaches that suit different goals.
One is to maximize premium by choosing volatile but trendy stocks. The goal is to buy them during a period of upward momentum, so you preserve or gain capital while simultaneously collecting large premiums due to the high implied volatility (IV).
With some luck, this can yield double-digit returns on a monthly basis. You’re pretty likelier to enjoy that at least for a while. But in the longer term, odds are high that the stock will plunge (which depletes your capital) or potentially skyrocket past your strike (in which case you would’ve done far better buying and holding).
This is fairly popular, and certainly fun to play with on relatively small positions, but I don’t recommend it as a core strategy.
The other (and more prudent) school of thought is to seek modest but steady premium with dependable, even dull stocks. The goal is to buy the same shares you’d want to hold in a long-term portfolio, then use safely out-of-the-money calls to supplement the dividends and modest equity growth.
Realistic returns are something like 1%-2% per month on average, depending on how aggressively you choose the strikes. Ideally, this just feels like larger dividend checks to reinvest or to cover expenses. It’s delightfully boring, and that’s the point.
The best cheap stocks for covered calls
Depending on your definition of “cheap,” these are generally poor candidates for covered calls. Good ones are the exception, not the rule, and require diligent vetting to pick out from the junk.
Penny stocks tend to have illiquid options and wide strikes, not to mention their business risks.
Cheap but established firms are occasionally good candidates, but there’s often a reason they’re unexpectedly cheap. Be very careful that you’re not hopping aboard a sinking ship.
If you’re expecting a serious rebound, then you’re probably better off writing cash-secured puts (to reduce the chance of getting stuck with a stinker) and/or simply buying and holding shares (to profit from the full upswing).
Pardon the interruption, but if you're with me this far, then consider joining through this referral link to see *everything* Medium has to offer!How many shares do you need to write a covered call?
You’ll need at least 100 shares of the same stock in order to write a covered call. That’s because all equity options contracts — both calls and puts — correspond to 100 shares of the underlying asset.
Likewise, you’ll need 200 shares to write two covered calls, 300 to write three, and so forth.
That’s all pretty obvious…but it matters from another angle, too.
Your strike price is based on assumptions about how high the stock is likely to go. Choose too low, and you miss out on potentially huge upside. You can reduce this risk by writing two covered calls at different strikes and/or expirations. Consequently, if you like a cheaper stock as much as one that’s twice its price, then consider 200 shares and two (different) calls on the latter, rather than 100 shares and one call on the former.
Not to say you should do that, since it’s obviously situational and subjective, but it’s a good way to retain some upside exposure.
Buying 0 shares with a “poor man’s covered call”
For a poor man’s covered call (PMCC), you simply buy a longer-date, deep in-the-money call option as collateral instead of 100 shares. This often costs just 25%-40% as much as buying 100 shares.
However, because no shares are involved, a PMCC is technically a diagonal debit spread, not a covered call. I won’t get into this strategy here for two reasons:
- It’s more complicated. It introduces a second contract whose expiration and delta need to make sense relative to the short call. You may also need to manage this long call separately from the short call. Dealing with shares is simpler, period.
- It requires additional options permissions from your brokerage. Level 1 (essentially the default) is sufficient for covered calls, but you’ll need level 3 for spreads like the poor man’s covered call. That’s an easy one-time update, but you may or may not be eligible.
It’s worth having in your toolbox, but not remotely necessary. I prefer either a) to avoid the complexity of spreads altogether or b) to sell vertical credit spreads for generally better returns on capital. Consequently, I seldom use a PMCC in practice…but it does have its place.
Is there an easier way to do this?
What if you like the covered call strategy but don’t want to manage it, choose stocks, or dedicate 100 shares’ worth of capital to a single position?
Are you out of luck?
Not exactly. Several ETFs use covered calls (and perhaps other strategies) to provide very high yield and flat-to-moderate price appreciation.
Best of all, you can purchase single or even fractional shares. It’s suitable for small portfolios, and even lets you dollar-cost average into a (sort of) covered call strategy.
Of course, these funds also have unique complexities and drawbacks, so go here to learn more:
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