How To Analyze Covered Call Trades

The previous articles covered in detail where losses come from in covered calls, as well as the elements of trade selection that really matter. While there many possible approaches, I prefer a process that discards poor trade setups as early as possible, so that as little time as possible is wasted on them. I begin with the information presented on the list. Then I quickly view a chart, even though fundamentals rule the selection process, since if the chart disqualifies the stock, there is no point going further. But if the fundamentals do not appear to be there, I will not even pull up a chart on the stock.

It is difficult to lay out a truly comprehensive yet flexible analytical process that is not discouraging to less-experienced covered writers. But do not be discouraged, please! After you become comfortable with the process below, you will find that it is all based on common sense and is actually rather easy. The initial attempts at trade analysis will be slow and cumbersome as you integrate this knowledge base. But you will become faster at it. In fact, you will develop the ability to winnow through many trades in a few minutes, almost instantly eliminating the no-go trades, and feeling certain that you have wisely selected the stocks that you write. And it will begin happening much more quickly than you would believe.

There is a reward hidden in this process: by using it, you will develop a well-rounded set of skills that enable you to invest with power and flexibility. No paint-by-the-numbers system has much flexibility, and the number of moving parts in the market is too great to fit into any neat mechanical scheme. Markets can change and do unexpected things. The moving averages and indicators that show predictive power for a stock can change, and a stock’s price behavior itself can change. Fads in industries come and go, which can move even good stocks. A completely rules-based approach works when it works and frequently fails due to lack of comprehensiveness and flexibility.

A good example is the interplay of high premium and implied volatility. Sometimes IV is high enough to cause concern. But when IV is in line with the stock’s historical volatility and the stock is one that meets our technical and fundamental requirements, IV is of no concern. Thus one who tells you that IV is not important will be right, sometimes; and dreadfully wrong, other times. Another example: some teach to avoid stocks with earnings approaching soon. This is a sensible practice, though inconvenient during earnings season! But some stocks are potentially dangerous at earnings, others much less so. Doesn’t it make sense to employ a methodology that enables the writing of the right stocks at earnings time, instead of avoiding them altogether? Which approach exhibits power and flexibility?

The constant, for stock selection as in most things, is quality. The constants for success in investing are and always will be patience and discipline. But the good news is that, when your writing is confined to conservative stocks, and you carefully apply sound fundamental and technical analysis, it is simply difficult to go wrong. Losses should be few and small. Here are the advantages to learning and deploying my flexible approach:

  • You will select stocks that are the very least likely to suffer real price damage and that will hold value far better than the average stock.
  • You will be investing, not speculating, in very high-quality stocks that you are forcing to yield up a nice income; it doesn’t get much more conservative than that.
  • Because the stocks are of high quality (and so long as they remain of high quality), you can be comfortable holding and writing them through price declines.

Enough palavering, as the cowboys say. Let’s get down to the nitty-gritty of selecting the best stocks for covered calls. I’ve also included a section just for newer writers.

The Analytical Steps

This is the process that I have used and that many successful covered call writers use. If you are experienced at writing, then customize it as experience dictates. Newer writers should stick close to the process below until they find their sea-legs. Don’t worry, with more experience under your belt you inevitably will evolve a process that works best for you, and sanding down its rough edges will bring speed and agility. Let’s get to it.

1. Review the Market

There is no point looking at potential trades if you don’t know what the market is doing. If you are customarily in the market, then you should be aware of this. If you are not on top of current market action, start with a weekly chart of the SPX and DJIA to get a sense of the market’s long-term direction, then move to a daily chart. Use moving averages and draw trend lines, because it is important that you develop a feel for its direction.

2. Select a List of Trade Candidates

Find lists of high covered call returns provided by other services or employ some type of scan that produces a list of trade candidates, which a few websites offer. However it is done, start with a list of high-returning trades and select from those, because we are income investors, not investors.

Because lists and scans provide stocks by option expiration month, you must also decide which expiration month’s returns you wish to view. If little time is left in the current month, you might wish to view returns for the next month.

3. Quick Scan

Don’t launch into intense analysis of each trade candidate that intrigues you, because this wastes too much time. Instead, scan the list visually for potentially good trades from a fundamental standpoint. The initial scan, which takes a few seconds for each trade candidates, consists of four elements:

  • Average Daily Volume – select stocks with at least 1,000,000 shares.
  • P/E Ratio – the P/E ratio should be 60 or less, and that is high for conservative trades; it also signals that the company is profitable.
  • Open Interest – prefer call series with at least 2,500 contracts outstanding.
  • Call Return – Find return levels that are acceptable. A return of less than 3% for 30 days is not very attractive, and more than 6% suggests high implied volatility; conservative stocks seldom have a higher return than this, if even that high – but we get lucky sometimes.
  • Earnings Due – During earnings season, check for an earnings report. Preferably, earnings are not due during the expiration month written or the three or four trading days following expiration. If earnings will be reported, use the earnings analysis in this article.

It is possible, and reasonable, to fudge a little in a strong bull market, during which any decent company should be doing well. A very strong industry also provides some cover for lackluster companies. The larger the company, the more I am willing to fudge. It is frequently possible to keep writing them even if they surprise to the downside.

The list consulted will likely have pre-qualified the stocks included, by market capitalization or other parameters. If using a scan, you can select certain parameters.

4. Technical Scan

If the stock meets the above tests, open a stock chart. We should already know the market’s direction and assess the chart in that light. The list below summarizes the process for evaluating the chart, discussed in detail in the preceding section. With a bit of practice you will be able to take this all in at a glance.

  • Direction – On a daily chart, determine the stock’s trend or trading range. Draw a trend line if the trend is not obvious.
  • Volume – Are trends and reversals confirmed by higher-than-normal volume? Is low volume creating a bearish divergence from the current trend?
  • Moving Averages – Note price interaction with moving averages. An uptrending stock will be above the 50-MA. There should be no negative MA crossovers.
  • Support/Resistance – Note major and minor support levels and whether the moving averages or trend lines act as support and resistance. An uptrending stock that has recently tested support is strongly positive; a stock approaching or bouncing off resistance is highly negative.
  • Preferred – Choose a stock in an uptrend, or at least a stock no weaker than the market itself. Avoid stocks in a wide trading range unless they have recently tested support and begun a new advance in the range.
  • Discards – Avoid stocks with the following charts:
    • Unless the market itself is declining, a declining trend instantly disqualifies the stock. Declining stocks can be written with my Collar Trade strategy, however.
    • Stocks that are quite volatile can be dangerous, and rarely are conservative writes.
    • If you cannot determine the chart’s pattern, pass on the stock.
  • Weekly Check – Check the stock again on a weekly Make sure the stock is not approaching a reversal or failure point on the weekly.
  • Very Short-Term Trades – If the trade will be less than two weeks, view the stock on a 1-hour chart in order to assess the very short-term direction.

If this sounds like a lot to consider, it isn’t. With practice you will learn to take in all this information in less than a minute. You will learn to instantly discard charts that don’t cut the mustard, which is the entire point of looking at the chart first. The analytical process here is geared to the short-term write. If you are a practiced chartist, you will note other chart patterns that may be in evidence, such as triangles and wedges, pennants and many other reversal and continuation formations. Space does not permit coverage of such patterns, but pay attention to them if you recognize them and their significance. Though we are not technical traders, the chart does inform the trade plan. For example, we would not write OTM calls on a flat stock.

5. Fundamental Scan

Once the quick-scan and chart scans have yielded some potential trades, then the time to analyze them further has come. Someone once said that covered calls should never be written on a stock that the investor is not willing to own: the reason being that if you are not called out, you will own it. This is a good litmus test for a stock. If you are not willing to hold it in your portfolio, it is by definition not a conservative write.

The level of analysis to be done depends on several things: 1) your personal criteria for how much confirmation you require as to the stock’s quality, and 2) the stock’s index. For example, a stable and profitable S&P 100 stock requires less analysis than a smaller company. The following process is all that is required to get the requisite comfort level that a call write is conservative:

  • Valuation – We have already established that the stock is profitable. Now compare the stock’s P/E ratio to the industry; it should not be too much higher. Look also at price to sales and price to cash flow to make sure they are not unduly out of line.
  • Earnings Growth – Look for quarter-over-quarter or year-over-year growth in sales and earnings.
  • Fundamental Rank – Though they are not primary data inputs, a fundamental ranking such as MSN’s StockScouter can be helpful (ranking of 8 to 10 preferred).
  • Industry – Quickly view the industry’s health and performance. Prefer the industry that is showing current strength; more is better.
  • Historical Volatility – I prefer stocks in a volatility range of 25-50%, though I am comfortable with 60% for large-cap stocks. If volatility recently has been rising, I want to know why.
  • Implied Volatility (IV) – Observe the 10/10 rule. IV that is lower than historical volatility does not promise less future volatility – just that we are not being fully paid for the actual volatility.

The data is available from numerous sources. These are conservative criteria. Feel free to look at other data (e.g., insider trading), but in my experience the foregoing data points are sufficient. If, despite all your research on a stock, you find yourself somehow uncomfortable with a stock that meets your criteria, it is best to pass on it, because your subconscious likely is warning you off. Until we get a bit of experience we tend to feel that way about all trades, it seems, but I have found it unwise to ignore persistent feelings of unease.

6. Check for Other Profitable Strikes

Even though the call strike appearing on the list is enticing, there may be other call strikes on the same stock that are even more attractive in light of your outlook about the stock formed during selection analysis. The next section discusses how to use different strikes effectively.

7. News Scan

I leave this for last, because it is by far the most time-consuming. Under the “news” rubric I also include reading about the company and its industry. I check for news only if the 15/10% implied volatility test is met. The various approaches to checking for news are described above.