How To Find The Best Covered Calls

“Twenty years in this business convinces me that any normal person can pick stocks as well as, if not better than, the average Wall Street expert.” Peter Lynch, Money Manager

Publicly traded companies are required by the Securities and Exchange Act of 1934 to file certain reports, including quarterly and annual reports, with the SEC. The quarterly report on Form 10-Q contains unaudited financial statements and some brief commentary on operating results for the quarter. The quarterly report, which is filed for the first three quarters of the year only, must be filed within 45 days of the quarter’s end.

The annual report on Form 10-K must be filed with 90 days of the year or fiscal year end, and must contain audited financial statements. The annual report presents results for the entire year, including the fourth quarter, and is required to contain almost prospectus-level disclosure about the company and its operations.

Despite filings made by public companies and the wealth of information about these companies on hundreds of websites (Google, Yahoo!, MSN, etc.), there are only two sources of information about a public company: 1) the company itself, and 2) independent analysts, who typically are employed by brokerages and asset management firms. These analysts cannot be fully trusted, partly because of examples where analysts “shaped” their research reports to help their employer get business from the issuer, and partly because they usually have little hard information from the company and must rely either on educated guesses or sheer dead reckoning.

The company’s disclosures come in the form of SEC and other filings, press releases, conference calls and speeches. Neither can the company be fully trusted, because complete and unbiased disclosure is not a value for public companies. Their chief values are to avoid shareholder litigation and to not give competitors any more information than necessary about product sales, technology, marketing plans, etc. And the less they promise, in effect, the less they have to deliver. Thus, they report no more than the law requires, and typically finesse even that. Trying to dig segment or division information out of a company’s financials can be a hair-pulling experience.

Well, there is a third and rather indirect source of data: insider transactions, the term used for purchases and sales of a company’s stock by its directors, executive officers and 10% or greater shareholders. These insiders must file a report on Form 4, describing the purchase or sale of the company’s stock, instruments convertible into or exchangeable for stock, and grants of stock options and stock warrants, by the end of the 2nd business day following the transaction or event.

Thus a cascade of sales or buys, especially open market buys (that is, not the result of exercising a stock option) allows us somewhat to triangulate the insiders’ overall state of optimism or pessimism. More on insider transactions appears further into this series of articles.

With that background in hand, let’s now explore the process for analyzing potential covered call trades and selecting the best ones. The trade selection process is of vital importance in covered writing. The trade selection process is one of the three pillars of a prudent call writing method along with trade planning and trade management. Luck aside, you end right only if you begin right.

Buy-Writing Foundations

The approach begins with a search for the highest-returning covered call trade candidates. This means they will have high premium, and as noted above, high premium usually implies high volatility. But as we have seen, high premium does not always mean a high level of implied volatility. There is far more to stock selection than viewing a covered call list and assuming that any stock on the list can be written; they can’t. Since the goal is to select only stocks that are good for safe covered writing, we must first understand what is bad for covered writing.

Stock Selection – 70% of the Game

Covered call writing is not like directional trading, in which the goal is to time the movement of a stock. Covered call writing is a game of regular, incremental returns. The covered writer’s goal is to get in and out of the stock and pocket the premium income stream – without damage. The market timer can stand a drumbeat of small 5% to 10% losses when stopped out of trades, because the timer will have the occasional large profit. In fact, a really disciplined timer can be quite profitable with only 40% of trades winning.

However, the covered writer, who aims for consistent small returns, cannot stand the regular losses that the timer expects. The covered writer who consistently selects trades that deteriorate will either take too many losses – which wipe out an even greater number of positive returns – or the account will tied up in unproductive, troubled trades, effectively sidelining the writer from subsequent investments; this degrades income, not to mention the portfolio itself.

Therefore, the successful covered call writer must focus great attention on stock selection, because even intermittently poor trade selection makes it impossible to get returns with any consistency. Averaging 3% per month on covered call writes is a fine return, but a 15% drawdown on a trade will require 5 months of trading just to recoup the loss. And with a diminished account, it is all the harder to make up the amount lost.

Writing a stock solely to capture the fattest time value premium returns, without regard to operative fundamental and technical factors, is a recipe for disaster; and trust me, it won’t be long in coming. We can get away with this only in a strong market, and even then, we will get caught sooner or later.

Volatility – Actual and Implied

But, you may wonder, why NOT just select the highest returns available? How can forbearing to write them improve returns or reduce risk? The short answer is that extremely high premium return often signals high risk, and writing calls to obtain the highest available premium returns without regard to stock quality or risk will decimate your account, sooner or later. This is a logical place to recap for a moment the evils – and benefits – of volatility. If you suspect that we’re spending too much time on volatility, it is an inextricable part of options.

There are two reasons why time value premium becomes fat enough to offer an acceptable covered call return:

  1. The stock itself is volatile, and implied volatility is more or less in line with it;
  2. Implied volatility (IV) is significantly higher than actual volatility.

When we speak of the premium return, we refer to the time value portion of the premium on which returns are calculated and even more specifically to the rate of return for the time remaining to expiration. The higher the rate of return, the higher either actual or implied volatility (or both) must be. But the trades with extremely high returns always will feature high stock volatility or high IV, or both.

If two different stocks both had a volatility of 50%, for example, we would expect the option premium returns to be roughly equivalent, unless one had significantly greater or less IV. Suppose one of these stocks with 50% volatility has calls with an IV of only 30%? While this suggests a market expectation of lower-than-normal future volatility, it also means we are not getting paid for the stock’s actual volatility level. If the other of them has calls with an IV of 75%, then IV is quite out of line. But if historical stock volatility is 50% and implied volatility is 75%, would we not at least wonder what is driving IV heavenward (I don’t mean to suggest this is “heavenly”)? Absolutely! Wall Street does not give premium away, and IV is out of line with actual volatility for a reason.

But if IV is high and yet in line with historical volatility, another issue is posed. If the calls’ IV is 80% and the stock’s volatility is 80%, then IV is in line with volatility, and must decide if we wish to write a stock this volatile.

Writing covered calls ignorant of volatility is like dealing in gold jewelry with no knowledge of the gold content. If you were buying a gold ring, would you (other things being equal) pay as much for 10K as 18K? If you were selling the 18K ring, would you accept a 10K price? Volatility in covered call writing is much the same thing.

The good news is that most trades appearing on a list of the highest covered call returns do NOT pose such exaggerated dangers, particularly the high-quality companies. There are many stocks with a low-to-medium volatility level that offer monthly returns in the 3% to 5% range for a month, without inappropriately high IV, that are comparatively safe to write and which will yield consistent returns.

For consistent success, we must separate the wheat from the chaff, including volatility, which is one purpose of this trade series of articles. Our goal as covered writers is to choose stocks for writing with acceptable levels of premium return but which are unlikely to collapse on us, causing the account drawdowns that destroy consistent returns. We do this by avoiding highly volatile stocks and those with spiking IV. This is so important, it bears repeating:

  • Call option premium return is acceptably high, as is company quality;
  • The stock is not highly volatile and appears unlikely to actually experience real price volatility; and
  • There is no out-of-line implied volatility signaling a potentially dangerous event.

This largely sums up the entire art of conservative covered call stock selection. This is where you make or break your writing. Some feel that the analysis required to separate the ideal trades from the pack is too time-consuming, or boring. Yet it is precisely this analytical process that reduces and therefore controls risk in covered call trades. To those who say humbug, I suggest that it is easier to do the work up front than to nurse damaged trades that unproductively tie up capital and cause sleepless nights. Some writers are comfortable with higher levels of volatility, those who have earned their “sea legs.” But they usually are the very ones who avoid it.

Sure, you may ultimately manage your way out of many stock pullback situations. But the financial goal is to get in and out of the stock with the return intact and go on to the next trade or keep writing the stock, not to take a loss on closing or be stuck in an unproductive stock for months or years in order to avoid taking a loss. Thus once we have found an acceptable return, our job as income investors truly begins; we must analyze the stock.

The covered call writer may not be particularly damaged by a fall in stock price. A fine company whose prospects are not materially diminished can continue to be written for additional income. However, if the drop is severe and the stock no longer offers good premium, then the stock is impaired as an income-generating asset. If we sell the stock, or are called out at its new, lower price, a loss results. And the stock that can’t sell off has not been created. For this reason, we must answer the same question in every trade: why is this stock not going to hurt me?