It is difficult to describe all the many variables that come into play when one is writing covered calls. Investing involves a lifetime of learning; experienced traders still learn something new every week and few claim to having mastered all the variables. But some things, like the factors covered below that presage bad trades and losses, seem to persist over time. Here’s something else: the largest, most stable companies in the world are the most conservative stock investments. And not surprisingly, they are the most conservative covered call writes, as well.
While we are not forced to confine covered writing to the blue-chip stocks, quality truly is everything in conservative covered writing. Based on years of observation, I firmly believe that the developing covered writer should stick to the best-of-the-best companies until confidence is developed. But not everyone wants to write blue-chip stocks, nor is such a rigid limitation necessary. There are ways to reduce the odds against us when investing for income.
Putting the Odds in Your Favor
The real estate investor’s mantra is location, location, location. For the conservative covered call writer it is quality, quality, quality. We humans delight in quality and insist on it in everything from automobiles to wine. How odd, then, that many covered writers select low-quality stocks without a second thought. Novice investors often write calls on a stock yet have no idea even what industry the company is in. Such trades can only work through blind luck. There is a better way.
As with so much in life, consistently successful trade selection actually is less about what to buy than what not to buy. There are variables in any kind of investing or trading. In selecting and planning trades, the successful trader eliminates as many potentially adverse variables as possible from the trade. Investing is a game of odds, to an extent, since we must predict something in order to profit. Certain factors increase or decrease the risk, though some are more obvious or intuitive to us than others. We therefore can, to a great extent, predict the level of risk in any particular trade, barring of course the truly unforeseeable.
But since we must predict something in order to profit, we must (and can) put the odds in our favor by eliminating – to the extent possible – the danger factors, many of which are known and quantifiable. While we cannot know or take everything into account, and while we humans control little, except hopefully ourselves, we can exercise a type of control over the results of our investing through trade selection. This, admittedly, takes more time and effort than simply writing high returns. But the effort is worth it. Will you do the work up front, saving much grief and enormous amounts of time as trades progress, or will you pull your hair out trying to salvage bad trades? It is your choice.
Have you ever played casino craps? I once bought in $100 of chips at Bally’s and shot craps for hours; now up $150, now down to $45. But it was not unusual while I played to see a parade of impetuous players lose thousands in a matter of minutes. Why? Because these plungers chose the low-probability bets – the hunch bets like the middle layout bets – just as many traders do. I would never tell you that casino craps is conservative, but it can be played in more- or less-conservative fashion; or with no discipline at all.
The good news is that there is no need to roll the investment “dice.” You CAN reduce the odds against your trades. The dangers lurking in a covered call trade can mostly be quantified and assessed in advance. But to do this successfully, you must know what to look for and, what to look out for. Truly conservative call writing is about what to avoid as much as what to choose.
It is a fact that many investors do poorly, or less well than hoped, because of failures in patience and discipline. Playing hunches, not analyzing the stock, panicky reaction to adverse stock moves, letting greed overpower reason, placing trades on stock tips… these and more are the bad habits that waylay even experienced investors. We’ve all done one or more of them.
Now add to that list: lack of skill and knowledge. Even if you are patient and disciplined, you must have the knowledge of what to do and what not to do for consistent success. Among the chief things you must know is how to select the best, conservative trades. This is the lodestone of covered call writing.
But why is a covered call trade conservative on the one hand, or a shot in the dark, on the other? What makes a company an excellent covered writing candidate, or a bad one? In the next section we will explore why trades go bad, and why companies are good, because you must grasp the pitfalls – the sources of risk – in order to understand how to avoid and control it.