“More covered call fundamentals and some great basic trade strategies to fit just about any writing style”
Newer covered call writers tend to focus on selling call premium (or more precisely, time value premium) as the only source of returns; and frequently think that’s all there is. But while writing calls is the strategy’s heart, it is only one dimension of covered writing. The sources of profit listed below will be covered in detail in other articles, but this list sets the stage for the more advanced topics.
Selling time value premium in the calls:
The classic buy-write strategy is to sell time decay: writing current- or near-month calls with good time value premium, which allow the writer to take maximum advantage of time decay. Upon option expiration, the writer is either assigned or sells the stock to find another trade. If premium remains high and evaluation indicates the stock continues to be a good candidate, it can be written again.
OTM Writes; additional profit when stock rises:
When OTM calls have been written, assignment produces an additional profit equal to the difference between the call strike and the price paid for the stock. However, it frequently happens that the stock will in fact rise but not enough to result in assignment, and an extra profit results nonetheless from selling the appreciated stock at a higher price. This seems to happen at least as often as assignment in OTM writes.
Implied volatility collapse (the early close):
The buy-writer sometimes chooses to sell high IV, where the high IV is event-related and the writer does not expect the event to produce real volatility in the stock. When the high IV collapses, it usually is possible to close the trade profitably, much earlier than anticipated. Profitable early closes of stock-based covered call trades mostly come from collapses in high implied volatility in tandem with a rise in stock price.
Trading the short calls:
Stock prices oscillate, and as the stock pulls back it is possible to repurchase the call for a lower price than it was sold. The call can then be written again as the stock price snaps back. This process produces a trading profit and it sometimes can be done multiple times in a month. Experienced writers sometimes prefer stocks with a wider average trading range for this reason, which are a bit more volatile than the ideal but produce more trading profits.
Rolling the short calls up:
Buying back the calls sold and selling calls with a higher strike price and/or further expiration month is known as rolling the calls up (or up-and-out). This technique allows the covered writer to squeeze extra profit out of a price rise, though it does increase capital tied up in the trade, and therefore increases position risk.
Adding options or spreads to covered call positions:
To further increase profits in a rising covered call position, or take more out of a falling stock, or to profit from the rise of a stock that is below our cost basis (meaning we don’t want to write calls on it at this level and risk being called out for a loss), it is possible to add a bull or bear spread, long options or naked options to the existing position.
Trading long protective puts:
Protective puts will increase in value as the stock falls, and lose value as the stock recovers from a pullback. The long puts can therefore be traded just as the calls can, with the stock’s price movements.
Many covered call writers only use two or three of these techniques, and it is by no means necessary to master – or even use – them all.
The most basic variant of covered call writing is simply writing calls and letting the trades go to expiration, then selling the stock if not called; or writing additional calls if premium remains acceptable. While it can work quite well, it obviously misses other profit opportunities noted above. Really, it all comes down to how actively you wish to trade and the level of return sought.
I have noticed through the years that this is an evolutionary process. Newer traders tend to freeze up when the stock pulls back and then are relieved and grateful when it recovers – if they haven’t already stopped out of the stock for a needless loss. Over time they learn that stocks and markets oscillate and correct as a natural thing. Sooner or later it occurs to them to close the calls on a pullback and at some point to write calls again on the stock’s rebound. This is the genesis of trading the short calls. The same process happens with rolling the calls.
Primary Sources of Risk in Covered Call Trades
As observed in other articles, the stock is the “biting” end of the covered call trade. Serious losses are almost always the result of a collapse in the stock or overall market. Yet the process is a bit more subtle than that; subtle enough that more explication is helpful.
Collapse in the stock’s price:
Any stock can collapse in the right circumstances. While this rarely happens with disciplined stock selection, it can happen to anyone. Luckily, it is not that common for an excellent company’s stock to completely collapse all at once, giving no opportunity to manage the trade to minimize loss. Good trade selection and trade design (both discussed further on) can meaningfully control risk, and my unique Collar Trade (protected buy-write) covered call trade limits total risk in the trade to a few percent of your investment.
The Assignment Trap:
When the stock pulls back, covered call writers frequently will write calls with a strike price below the position’s cost basis. But if the stock recovers, the writer must either suffer being called out of the stock at a loss or buy back those calls and write higher-strike calls, which adds a needless debit in the trade. I refer to this situation as the assignment trap, and discuss how to deal with it further on.
Rolling Calls Up on a Price Spike:
Conversely, when the stock rises, the call writer sometimes will buy back the short calls and then write new calls having a higher strike price (rolling up). Though it increases the cost basis in the trade, the roll up can dramatically increase the profit in the trade – if the stock holds the higher price or even better, goes yet higher. But if the stock advance was only a brief spike, the roll up will leave the writer stuck with an increased cost basis, which frequently results in a loss.
Add-on Option Positions:
Losses also can occur from putting on long or short options or option spreads in connection with a covered call trade, whether done to hedge the position or to grab extra profit from the stock’s movement. Such add-on strategies should be done only as experience grows, never in panic and never in a spirit of greed, both of which tend to be unreasoning impulses.
In my experience, most of the time these losses are the result of failures in discipline, meaning a failure to properly analyze the stock or evaluate the stock’s movement. There is no doubt in my mind, based on years of experience, that poor trade selection is what ejects more new players from the covered call game than any other factor.
Yet even when trade selection is disciplined, reacting too soon or inappropriately to stock moves is far more often a cause of losses than catastrophic stock failures. Risk is compounded when the writer does not know how to properly react to stock movements. Trade selection and trade management principles are covered in depth in other articles.
With that foundation laid, it is time to look at some of the more common covered call strategies. Not all of them will suit every trader’s taste, of course, and there are variants even of these common strategies. But as we will see, there are strategies to suit everyone’s predilections.