by Mike Scanlin

How to write covered call options: Buy Stocks. Sell Calls. Earn Income.

That's what the headline says, and that's what we're going to do right now.

The example stock we're going to use is the iShares Russell 2000 index ETF (exchange traded fund), symbol IWM. It's a collection of 2000 stocks that trades like a single stock. We're going to use it as our example stock because (1) beginners should stick with diversified ETFs to remove single stock volatility, (2) it's highly liquid (small spreads are good for small trades), and (3) it happens to offer good covered call returns.

On Friday (Sep 3) IWM closed at $64.33 per share. In this example we are going to buy 200 shares and then turn around and sell 2 call options against it (since 1 option controls 100 shares, see Tutorial).

Covered call trade part 1: Buy Stocks.

On Tuesday, Sep 7, place an order with your broker to buy 200 shares of IWM. If you get filled at 64.33 per share this will cost you $12,866 plus commission (which we are going to imagine is small enough not to matter -- if you pay more than $5 commission to execute a trade like this then you may want to look for a discount broker, see StockBrokers.com Annual Broker Comparison.

Covered call trade part 2: Sell Calls.

As soon as you buy the stock, place an order to sell 2 (not 200) call options with an expiration date of September 18 and strike price of 63. Based on Friday's close, you should be able to sell them for 2.10. You will receive $420 (2 x $210) into your account today (remember, 1 option controls 100 shares, so when the price of an option is quoted as $2.10 that means it's really $210 for a single contract).

Here's what we've done:

So, you've invested a total of $12446. You are long 200 shares IWM and short 2 Sep 18 63-strike call options. Now what?

Cover call trade part 3: Earn Income.

Now we wait. Because options are a decaying asset they lose value (time premium) as each day passes. If the underlying stock price doesn't change then you should see the time premium in the option drop a little bit each day. That is the amount of daily income you are earning.

If IWM is over 63 (the strike price we chose for the options we sold) by expiration on Friday Sep 17 then your options will be assigned (exercised), meaning the person who bought them will force you to sell your 200 shares for $63 each. You will lose the IWM shares and receive $12600 (200 x 63) cash into your account on Sep 18 (this happens automatically, you don't have to do anything special).

Since you received $12600 and you had initially invested $12446, you have made a net profit of $154 (minus 3 commissions -- one to buy the stock, one to sell the options, and one to sell the stock via assignment of the options).

If you divide your profit by the amount of initial investment (154/12446) it works out to 1.24% in 11 days. If you annualize it (that is, divide 1.24% by number of days you were in the investment and then multiply by the number of days in a year, 365) then you get 41%. That means if you were in a similar investment every day of the year you would make 41% for the year. That's over 3%/month, and really quite good (don't expect 3% every month; it is unlikely to happen).

But what if IWM goes down?

If IWM is less than 63 (the strike price of the options you sold) by expiration on Sep 17 then the options you sold will expire worthless. You keep the $420 you sold them for, and you keep your stock. Now you can either sell the 200 shares of IWM you still have, or you can write another 2 call options against those shares for the October option cycle (when the market opens the following Monday, Sep 20).

Your break even point is now 12446/200 = $62.23 per share (recall that IWM was at $64.33 when we started this trade, but our break even point is lower because of the calls we sold). If IWM is over $62.23 then you have a profit (on paper) and if IWM is less than $62.23 then you have a loss (on paper). In either case, now you can sell October calls against the shares you own.

If you need more help on how to write covered call options, there are additional examples in our covered call tutorial.

Mike Scanlin is the founder of Born To Sell and has been writing covered calls for a long time.