How To Write Covered Calls

As noted earlier, while we evaluate the stock as a viable trade candidate, we also are sizing up the technical picture. That is, we are also forming a neutral, bearish or bullish outlook on the stock. It also is helpful to look at the premium returns in other call strikes and for at least the next expiration month (particularly if the current month has little time left).

Developing Our Trade Outlook

Some advise to always write the current-month ATM call for the fattest premium return, or to always write the nearest OTM call. But a rigid approach to strike and month selection does not make sense and will needlessly limit returns, or worse. The ATM call used on a bullish trade leaves too much on the table, for example, and the OTM call’s small premium and low delta make it a poor choice for a bearish or neutral trade. The primary factors in strike and month selection are these:

  1. Technical expectations for the stock, in light of market and industry conditions.
  2. Volatility factors, historical and implied.
  3. Where the best premium return is found.

Technical Expectations

Technical analysis should be geared to the expected duration of the trade. If writing the current or next month, then we are most concerned about the short term direction. If writing months out, then we may be more concerned with the medium-term prospects as demonstrated on a weekly chart. Thus if the stock is in a longer-term uptrend but temporarily pulling back, the short-term writer would treat it as a declining stock; the longer-term writer as a rising stock. The short-term writer might view a ranging stock bearishly if falling in the range, but bullishly if rising from the range’s bottom.

Stocks are either trending up, trending down or ranging. The strength of the trend will vary, as will the size and consistency of the range. By “ranging” I refer to a stock in an established range, not just a brief congestion pattern. But we should be able to determine what the stock is doing. When we cannot divine the stock’s intentions and cannot form a clear outlook on the trade, it is better to avoid it.

Volatility

While we can roughly gauge historical volatility, it is instructive to actually view the volatility percentages. You simply must know if the stock is volatile, and how volatile. It is common for inexperienced investors to write a stock such as Rambus (RMBS) without realizing that it may have a historical volatility over 100%, which is quite high. Then when the $40 stock quickly turns into an $18 stock, they feel shocked and betrayed, even though the volatility evidence was there in plain view – had the writer looked. View historical volatility as a police officer would a rap sheet; high volatility is suspect.

Premium

Despite the outlook we develop on the stock, and the trade strategy that it suggests, premium might not cooperate.

The following guidelines have worked well for me over the years. They were developed by my own trial and error and also from trades analyzed over the years. Matching the trade construction to what the chart is showing us is sensible in theory, and in years of experience I have found that it works very reliably on established, high-quality companies that are not highly volatile. On the other hand, nothing works with great reliability on companies that are small or volatile.

1.Determine your technical outlook for the stock.

Short-Term Bullish – A strong and imminent price rise is expected, whether technically or fundamentally based. The stock may be bouncing off support, expected to move on news, be in an uptrend on a daily chart, etc. This also includes stocks trading in a wider range that already have bottomed in the range.

Generally Bullish – A price rise is expected over time but perhaps not immediate or strong. The better trade candidates combine strong fundamentals with a clear uptrend. A healthy industry and market are of course pluses.

Neutral – Not a lot of price movement is expected short term; such a stock usually is trading in a tight price range and no major news is expected. But when stocks trade in a wide range (classic “rolling” pattern), the short-term expectation is of necessity bullish or bearish. Stocks are seldom neutral over the long-term, except for established “undervalued” companies that trade at very low PE values, usually at or below book, and have done so for a long time.

Generally Bearish – A pullback is expected but not necessarily major and imminent. This usually arises from a stock in a medium- or long-term downtrend.

Short-Term Bearish – A strong and imminent pullback is expected. The stock is in a clear downtrend on a daily chart, has failed at resistance or is approaching strong resistance (in a range or otherwise), we suspect a sell-off on an earnings report, etc.

Bullish Short-Term, Bearish Long-Term – This stock is in an uptrend or bouncing off support on a daily chart, but is bearish on a weekly chart. A typical example is the stock rising on a daily chart but approaching a clear failure level (trend line, etc.) on a weekly chart.

Bearish Short-Term, Bullish Long-Term – The stock usually is falling toward a strong support level though uptrending in the medium to long term, as evidenced on a weekly chart.

Short-Term Congestion Pattern – The stock has recently been in a tight trading range. While the very short-term outlook may be neutral, pay more attention to the medium- or long-term outlook, since congestion patterns tend not to last long. If the stock has been in a tight range for months, then the market considers it fully-priced, which will change when the company’s prospects change. Heavy insider selling in past months is a very negative sign.

  1. Observe support and resistance levels.

Never forget that the market is seeing the same chart that we are. In the course of trade selection we note support and resistance levels. If the stock is about to test support, I wait for the test to be concluded or more usually move on to another trade. When the stock has moved well above a major support level, be aware that at some point it will pull back. Note carefully the closest support levels and their relative strengths. When a stock has been rising strongly and left support far behind, the fall to test support will be a long one.

It is best to avoid the stock at or approaching resistance, since we can expect it to fail there. The stronger the resistance, the truer this tends to be. If a breakthrough is expected, fine; but wait for it to occur. Though there are ways to write the declining stock, are there no better trades to be found?

  1. Consider the market and the strength of the industry.

It can be assumed that the best stocks in an industry will rise with it; even the weaker stocks may benefit from its strength. Selecting strong stocks in a strong industry makes good sense, and these are classic OTM writes. Stocks in a neutral industry can work well. Writing stocks in a weak industry is less predictable and must be done with caution. Stocks usually will decline with the industry, and the stronger the overall decline, the more energy a stock must have to resist it. Even when a stock is trending up in a falling industry, expectations for the stock naturally will not be as robust as if the industry were healthy.

We also cannot view a stock in isolation. It must be compared to its index (e.g., the S&P 500, Nasdaq Composite) or the overall market. In a bull market, a falling stock demonstrates weakness; a bullish market doesn’t want it. If the stock is merely lagging the market, this may not be cause to avoid the stock, but it seldom will be a compelling write, either. In a bear market, stocks commonly will be following the market, and successful writing nonetheless is possible. Stocks showing more strength than a bear market can be found. If the market recently has been flat for a few months, we prefer a stock doing no worse than the market. If the stock has been ranging for a while, in an up market, we can take advantage of the stock when moving up in the range. But remember that 1) it will not range forever, and 2) it is weaker than the up market.

  1. Confirm the daily chart with the weekly chart.

It is not unusual to see that a stock uptrending (downtrending) on a daily chart is in a long-term downtrend (uptrend) on a weekly chart. If the stock is not called away, you will continue to own it, so the longer trend cannot be ignored even if you are a dedicated short-term writer. Many times a stock that appears bullish on a daily chart will sell off when it hits the medium- or long-term downtrend line, as the weekly chart would have foretold (had it been consulted).

  1. Determine implied and historical volatilities.

It is quite helpful to look at the 10-day, the current 30-day and prior 30-day volatilities to get a feel for how much volatility the stock exhibits normally. As noted earlier, we also determine the call’s implied volatility to see if it is in-line or high. Is actual volatility rising, falling, or about the same? Apply the 10/10 Rule to determine if IV is significantly higher than historical volatility; if it is, determine why or pass on the trade. While we can be more forgiving of a General Motors, be careful here. IV spikes for a reason.

  1. Determine where the premium is.

Look at different strikes and any expiration months that interest you to compare premium rates of return. Identify where the fattest time value call premium and thus the most return lies, in addition to the trades presented on our lists. Having formed a technical and fundamental outlook for the company, it is a matter of determining whether premium for the strike(s) and expiration month(s) of interest to you are acceptable. Making notes as you go will save time.

  1. Check put costs as a back-up strategy.

If neutral or bearish on the stock, consider the Collar Trade strategy (discussed further on), in which we purchase an extremely cheap long-term put to protect the stock. Any other put structure tends to be too expensive and eat up too much of the call premium. Delta for a multi-month put will be low, therefore it serves only as insurance against a stock price collapse; the low delta makes it unsuitable for trading as the stock price moves. If options are expensive, the protective put “back door” really is closed, since we sell volatility, not write it. If we buy an overpriced put and volatility collapses, we would lose money on the put from a collapse in implied volatility, even if the stock does not move.

  1. Be clear whether you wish to keep the stock, or not.

Are you determined to keep the stock, or do you prefer to sell it? Or does it not matter (which gives the most flexibility)? Writers may not want to be called out of the stock because of low cost basis or accrued holding period. When we really are uncomfortable holding a stock, it usually is better to sell it.

KEEP: Write OTM, perhaps a month or two out for higher premium, being prepared to buy back the calls to protect the stock. Best practice is to write stock at failure points (string resistance level) and close the calls profitably as the stock price falls.

SELL: Write ITM to better assure assignment; writing further out brings in more premium, but increases trade duration. Decide what is most important to you.

DON’T CARE: We are free to construct the most advantageous trade without fear of assignment.

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