How To Create A Covered Call Trade Strategy

After you have sized up the stock (hopefully, the market and industry, as well) and formed an outlook for it, you are satisfied with volatility and implied volatility levels, and you know where the acceptable premium returns are. You are ready to construct the trade.

Capture Time Decay – Write the current-month ATM or OTM calls. Since time value is what decays, you want a premium that is all time value, and the greatest time decay is realized in the last 30 days. If bullish, the OTM offers more profit potential despite the smaller premium. It is possible to close the call at a profit close to expiration and rewrite the stock for the following expiration month. Time decay plays are done where the outlook is neutral or bullish.

Capture IV Spike – For news plays in which you doubt the news is important enough to materially move the stock, even though IV is spiking, write ATM or ITM calls. It can increase returns to write two or three months out for higher premium, since their time values also will collapse on the news release. The more significant the news in relation to the company’s size and prospects, the riskier is the write. Mundane news on a large, established company is the safer bet, although this technique is not for the faint of heart. What is interesting is how often inexperienced call writers select the high-IV trades without knowing it.

Short-Term Bullish – Write the current OTM call in order to capture as much of the price movement as possible; we profit if the stock moves up before expiration, even if not enough to result in assignment. Consider buying the stock and waiting for a price advance before writing the calls (known as legging in), which can improve returns considerably. In either case, we should expect price gain during the expiration month to be written, obviously. A popular technique is to buy the stock when both the stock and the market are having a down day and write an OTM call; the market does the work that allows us to capture the stock’s natural snap-back.

Generally Bullish – Write the current OTM call to capture as much of the price movement as possible, especially if the down-day-writing technique is used. Second choice would be the current ATM call, which maximizes the writing return but does not share in price appreciation if the bullish outlook is correct. If the stock price is between two strike prices (ex: stock is 42.10, right between the 40C and 45C), results generally will be better with the OTM strike.

Neutral – This is the classic ATM write in the current month, which maximizes return per period; or the next month if little time (and thus little return) remains in the current month. If the down-day- writing technique is used, write an OTM call to catch the stock’s snap-back.

Generally Bearish – Write current ITM calls for downside protection and to increase the chances of having the stock called away. The return should be at least 2% per month (30-day write), though better returns can be found. Next-month ITM writes can be productive but try to get at least 2% per month. It is important on a declining stock to continually lower our cost basis in the trade. ATM writes, while more profitable at the time of writing, are very aggressive and do not lower our cost basis. After a string of writes on a declining stock, the ITM writer should (unless the stock is really selling off) have kept cost basis at or below the stock’s price. The ATM writer on the other hand will be sitting on a price-impaired stock with a basis well above market price.

Short-Term Bearish – Call writes are best deployed on: 1) portfolio stocks we prefer not to sell and 2) quality stocks of medium-level volatility that we write through all markets to generate income, without regard to their price, because we are confident in them for the longer term. Write the ITM call in order to lower basis. If you want to keep the stock, be prepared to buy back the calls close to expiration, when they have lost almost all time value. Or the calls can instead be rolled down, or down and out depending on premium and your outlook for the stock at the time.

Bullish Short-Term, Bearish Long-Term – The conservative writer treats these as bearish plays, partly because the stock is lacking in energy and the market knows it; and partly because if you are not called out, you may be in the position of owning an asset in decline. Despite the bullish short-term outlook, the OTM call is not indicated, since assignment is the goal. The ATM or ITM write is the better play. It can be written bullishly, with an OTM call, but the longer-term bearish trend will reassert itself at some point, and if not assigned, we will still own the stock. Such a stock can be ideal for the Collar Trade strategy, however.

Bearish Short-Term, Bullish Long-Term – These should be written ITM if at all; our goal is to be called out. It is simply better to wait until the bullish movement appears, assuming call premium is acceptable at that time. Buy-writes on dropping stocks can be done successfully, but why choose one if there are better candidates? On a short-term write, it is difficult to find a put that is both truly protective and reasonably priced. And a bullish move in the stock will leave the put strike high and dry and impair or wipe out its value.

The Resistance Double Play – Strong companies in a proven uptrend that appear due to pull back to the 50-day moving average or the trend line are candidates for a resistance double play, a definitely directional and technical write. The writer purchases an ATM or slightly ITM put, if not overpriced (very important – its IV should not be greater than the stock’s historical volatility and preferably less) and waits for the test of support. When it occurs, the put is sold. If the stock does not pull back on the assumed time line or shows signs of continuing to advance, sell the put before either time or a stock rise erodes its value further. When convinced that the test of support has been successful, the stock is purchased and an OTM call is then written in order to catch the stock’s snap-back from support. Or wait to write the call on the advance (leg in), if you prefer. This strategy does not reward the sloppy technician or one who misses news.

Longer-Term Writes – Some prefer to write calls five months or more out in time (multi-month calls). Premium return will dictate the strike chosen. A conservative technique that can offer good returns is to find deeply ITM multi-month calls with good time value, which can make it possible to lower the trade’s breakeven point close to or below long-term support – this strategy is sometimes referred to as a “simulated CD”. The writer should be neutral, slightly bearish or slightly bullish for this strategy. If extremely bullish on the stock, shorter-term call writes provide better return due to premium compression. This strategy is a poor fit for an extremely bearish outlook.

Support Level – A conservative (but not vital) practice is to design the trade so that the trade’s breakeven point is close to a support level, or even below it. However, on a rising stock this means writing ITM calls to lower breakeven so far. I have not found this to be necessary, but it is quite conservative. Because there is a cost to buy back the calls, this does not always avoid a loss.

These by no means represent all the possible trade construction strategies nor all the possible situations with which covered writers may be faced. They are not intended to be used as fixed, paint-by-numbers rules. They are usable guidelines for fitting your call-writing strategy to the stock. I cannot stress enough to match the call write to the chart and to pay careful attention to volatility and implied volatility. The difference it will make in your results will be significant.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.