How To Trade Covered Call Options

The market, like the Lord, helps those who help themselves. But unlike the Lord, the market does not forgive those who know not what they do.” Warren Buffett

A covered call write should be constructed to match both your expectations for the stock over the trade’s expected duration and your strategy. By expectations, I refer to technical expectations for the stock, perhaps its industry and the market. Unless you intend just to spin the bottle in running a trade, technical analysis will to great degree suggest in light of where premium return is found – which call strike call strike to write, and which expiration month. It will also indicate whether a protective put should be purchased.

When constructing a covered call trade, thoroughness would include considering the following factors:

  • Our technical evaluation of the stock, industry and market.
    Likely direction over the trade’s anticipated duration: trend, range, etc.
  • Support and resistance levels.
    Be clear where they are and their respective strengths
  • The level of return desired (and available) for risk undertaken.
  • Our preferred trade duration.
  • The trade strategy:
    Capturing time decay, playing implied volatility, timing a move, etc.

Optimum trade planning is just a matter of determining the best strategy for a trade and whether the best call strikes and expiration months for executing that strategy offer acceptably fat premium. Planning encompasses selection of the optimum strike price and month, but it is more than that.

Generally, the higher the call premium’s rate of return, the more volatile the stock or the more implied volatility the premium reflects. Yet we are not seeking volatile stocks, since the covered call is not the ideal strategy for trading volatility. The conservative method of planning the covered call position is based upon:

1) Selecting the expiration month that matches our strategy.

2) Selecting a call strike that offers an acceptable rate of return over the trade’s expected duration and that matches our outlook on the stock.

While future stock volatility can never be known, we avoid high-volatility stocks through trade selection, as described above. The expiration month and rate of return are chosen partly to match the writer’s personal predilections. As an example, one investor might prefer longer-term writes and another avoid them. In planning the trade, we are actually designing the position to meet our expectations for the underlying stock (and perhaps the industry and market, as well) formed during the trade selection analytical process.

The Chart’s Role in Trade Planning

Our expectations for the underlying stock and preferred strategy are paramount in proper planning. Our technical assessment will not always be right, but once we have approved the stock as a potential writing candidate, the technical picture heavily dictates the trade’s construction. This is not “directional” trading, however. Everyone who executes a trade must select it somehow; must predict something in order to profit. But as income investors, we are not constructing trades that only works if we are right on the stock’s direction (or stillness) and have the timing right. To the contrary, our goal is to capture income as conservatively as possible, without having to depend on timing the stock. Doing so means that we take a loss only if the underlying stock makes an adverse move, despite all due care in selecting and planning the trade.

Technical analysis, though admittedly imperfect, is a powerful tool for covered call writers. In fact, ignoring the chart is very dangerous for the covered call writer. We don’t need to get the direction and timing right, we only need not get it too wrong. For example, if Jack buys the 40 Call on a $40 stock, he only makes a profit if the stock gains more in price – by expiration – than he paid for the call, and could easily lose all or most of the calls’ cost if wrong on the direction or timing. If Jill buys the $40 stock and writes the 45 Call for a premium of $1.25, she makes a much larger profit if the stock rises enough that her shares are called away at $45. If the stock rises but not enough that the shares are called away, she will enjoy an additional profit upon selling the stock. If the stock rises not at all, she nonetheless has profited from writing the calls. If the stock falls, she has $1.25 in downside protection.

Jack had better have the direction and timing right. Jill only needs not to be catastrophically wrong in her stock selection, which is far easier than timing a stock.

Would any investor ignore the fact that a stock is selling off in a good market, or that the stock has been flat or in an uptrend for a prolonged period? The rational and informed investor of course would not. Nor have I ever read any author on the subject of covered calls who advised ignoring the chart. For the conservative covered writer, the chart merely informs the logic of a trade that meets strong fundamental criteria. Though it may seem that trade selection and planning are separate endeavors, they are inextricably intertwined.

While evaluating a stock as a possible covered call candidate at a broker like Ally Invest, which includes the technical review, we are simultaneously thinking how we would build the trade; our strategy. They are not really separate analyses. Put differently, if during technical review we like the stock: what, precisely, do we like? And what we like usually suggests what we should do. For example, during our evaluation of a stock we may notice that it has bottomed in a well-defined trading range and seems poised to head back up in its range. Does this not suggest a strategy of writing an OTM call to profit from the anticipated price rise?

Note that the stock’s fundamentals really are of little help in constructing the trade (selecting, yes; constructing, no). Sound technical analysis will improve returns because it gears trade construction to take advantage of what the chart says is happening in the real world.

Some Trade Construction Strategy Examples

Because our goal is to write for high premium, we must select a strategy that provides an acceptable rate of premium return while capitalizing on the stock’s technical picture. One trader might, for example, choose to write extremely high IV in the expectation that IV will collapse when a news event occurs without damage to the stock. Another might write deeply ITM calls in the expectation that the stock soon will pull back to a support level and rebound, intending to buy back the calls for a profit and rewrite the stock on the rebound. Another might simply write the current month ATM calls to maximize both time value premium and the use of time decay. Yet another might construct a Collar Trade trade to limit risk.

These are the kinds of concerns that a well-conceived covered call trade plan takes into account. The following examples use common situations to illustrate how your strategy and reasoned expectations for the stock might affect trade construction:

  1. Maximizing time decay:

Writing current month calls takes maximum advantage of time decay. The ATM and OTM calls are all time value while the ITM call offers far more downside protection. As expiration draws near, this writer can close the trade for a profit, or roll the calls out to the next month if premium and the trade’s outlook both are acceptable.

  1. Writing high IV in expectation of an IV collapse:

This neutral-to-bearish technique is employed on stocks with an approaching news event that is driving implied volatility and premium high but that is not expected to produce additional volatility in the stock. We write an ATM or OTM call in the second or third expiration month out in order to get more premium, since the time value of those calls further out will collapse when IV falls. If the stock’s technical picture is negative, this strategy is not indicated, with few exceptions.

  1. We expect a trending stock to pull back to support and rebound:

These tend to be stocks approaching to a range bottom or pulling back to a trend line or moving average. Write a deeply ITM call in the expectation of buying the call back at a profit when the stock pulls back. Writing a month further out will increase time value. Once the stock has fallen sufficiently to reduce the call’s price to a desirable level, buy the call to close (at a price lower than the selling price), which produces a profit. Once the stock snaps back from support, write more calls, or hold the stock for more gains. This is known as trading the call with the stock’s movement.

  1. Short-term bullish on the stock:

Write OTM calls in the current month or next month. If the stock moves up but not enough to get called by expiration, we still are in profit. Alternatively, leg in to the trade – buy the stock and wait to write the calls on the stock’s advance. We could also execute a blended write, writing calls with different strikes.

  1. The conservative writer who prefers not to write too actively:

Pick very high-quality, stable stocks. Write long-term ITM or ATM calls, either LEAPS calls or calls with a 6-month or greater expiration, that reduce the cost basis to a level that is at or below major long-term support for the stock. Dividend stocks increase the yield.

These examples of trade construction are soundly informed by the charts, fundamentals, volatilities and other data, and take maximum advantage of premium.

Most Popular Posts: