There are many variants of the buy-write covered call strategy. The simplest is to select the trade, buy the stock and write ATM calls; and it works. But there are strategies for writing hot stocks and hot markets, for writing bear markets, for writers without time to monitor trades every day, for technicians. Below I briefly discuss some proven buy-write strategies, and how and when to use them. These aren’t always totally separate styles or strategies with “Chinese Walls” between them. Many share some of the same characteristics, and writers frequently switch strategies to adapt writing to their lifestyles, or to adapt to the market.
It is not necessary that you exactly conform to any of these strategies; there are many variants. They make a great starting point for writers finding their sea legs. Feel free to find your own way. There is no right or in wrong in covered writing – only profitable and unprofitable.
Monthly Time-Decay Writing
This is the classic buy-write: buy stocks and write current-month calls with a month or less remaining before expiration. In fact, many of these trades are placed on the Monday following option expiration, which keeps the money turning, in banking parlance. These are trades with roughly 30-day duration; or less.
The rationale for this trade is partly time decay and partly premium compression. The further out in time a call is written, the more compressed premium becomes and the less the writer receives for it on a per-month basis. Thus writing approximately 30 days or less out from expiration maximizes the rate of return. And the time-value portion of premium decays the very most in the last 30 days of option life. Sometimes, when time value premium has decayed enough close to expiration, the writer can close the call and either write another call for the following expiration month (i.e., rolling the calls out) or simply sell the stock.
This investor hunts for quick writes in the last two weeks or less before expiration that carry high time value and yield a return of 2.5% or more on the funds invested. High returns over so short a period can indicate quite high implied volatility and actual risk, so the stock must be carefully vetted – volatilities in particular. Where IV is much higher than actual volatility, it is likely an event is pending.
Here’s a useful trick. Where premium is high in both the current and next month, it is generally safe to write the current month’s calls if the volatility event expected will occur in the next expiration month. The explanation for it is that, though the volatility event typically will occur in the next month, it nonetheless causes premium to be across both months. This two-month comparative is a technique I developed, which is why you have never seen it discussed or published before.
Though not foolproof, it works quite well if you are right that the volatility event occurs after the expiration of the current month. But you must confirm that! If premium is not also high in the next month, it rather suggests that the event (if any) driving option premium will occur in the current expiration month, does it not?
Of course, if implied volatility is in line with historical volatility, it may be a great write anyway.
Deep in the Money (ITM) Writing
The ITM writer concentrates on writing current-month calls that are deeply in the money, the goal being at least 15% downside protection. For example, if DELL were trading at $20 per share, the ITM writer would be looking for an acceptable return and a premium of at least $3.00, which is 15% of the stock price.
ITM call returns generally will be lower than those on at-the-money (ATM) call strikes on the same stocks, but there is a method to this call writer’s madness. Although the return may be lower, the deeply ITM call offers the biggest premium and thus the most downside protection against a pullback in the stock. In fact, deeply ITM writes are a method that can be used to successfully write large-cap stocks in a declining market, without a protective put.
But any comparison to ATM or OTM strikes aside, many devoted ITM writers would argue that real-world trading returns are actually higher over time, for several reasons:
- It is not difficult to find 3-5% returns with 30 days remaining on large, high-quality stocks.
- All things being equal, the ITM write is more likely to be assigned, meaning that ITM writers are less frequently “stuck” with down stocks that have to be rewritten.
- ITM calls have the highest delta and thus lose value closer to dollar-for-dollar as the stock falls; thus it is more advantageous to repurchase when rolling down or closing the calls.
- Trading the short calls, meaning to buy them back on a stock dip and write them again on the bounce-back, is far more profitable with ITM writes due to the calls’ high delta.
This writer should concentrate in large-cap stocks for additional stability (and slightly lower return), because deeply ITM calls confer no license to write poor-quality stocks. And it obviously is not the ideal strategy in a good market on rising stocks.
A variant of this strategy, which is especially useful in times of high volatility or uncertainty, is to write the calls 10 to 20 days ahead of expiration, to decrease the amount of time in the position. When volatility is high, as it is in 2009 so far, this technique not only works but produces excellent premium.
Out of the Money (OTM) Writing
One who writes OTM calls is – or should be – slightly to very bullish on the stock, looking for additional return from either: 1) being assigned at the OTM strike, or 2) selling the appreciated stock at a higher price even if not assigned. Returns of 15% to 20% upon assignment are possible in OTM writing. OTM writing works best, very generally speaking, when the stock is up-trending with its industry, when the stock has broken out of a trading range or when it is bouncing off support.
As a general rule for those wishing to bank premium, one would rarely write OTM except when convinced the stock price will appreciate before expiration. The reason is that OTM calls offer less time value premium and less downside protection than ATM calls. And as we have seen, OTM calls can be maddeningly slow to lose value on a stock pullback, due to their low delta. Therefore the OTM write should not be a routine or automatic choice for the call writer, as so many writings on the subject of covered calls would urge.
Beware of OTM writes on stocks that have gapped or spiked up, because they frequently pull back from what turns out to be a swing high. Let the move up prove itself at the new price range for a while; make sure it sticks. Spikes and gaps are far more dangerous than a stock moving up in a steady, volume-powered trend.
OTM writing works quite well on down-day covered call writes (discussed below), in which we write the stock on a day when both stock and the overall market are down. The snap-back in the market and the stock powers the OTM write. Figure 6.2 summarizes the relative advantages and disadvantages of writing OTM calls, below.
|OTM Call Advantages||● Big return if called out
● Increased profit even if uncalled, if stock is above entry price at
● All time value premium, thus time decay operates quite well
● Best choice in a flat or rising market for portfolio stocks that we
|● Small premium – low return if the stock does not rise
● Least downside protection
● Low delta means it is slow to lose value if it must be closed or
rolled down on the stock’s pullback
Leg-In Writes (OTM)
This strategy is a variant of the OTM write, but even more bullish in outlook. Assuming the stock in fact will rise as anticipated, it is far more profitable to buy the stock only and wait until it has risen before writing the calls. This is known as legging in, because the stock leg of the covered call is put on first. The calls may be written days or weeks later, depending on the stock’s movement and the amount of return sought. Using this technique can double or triple the uncalled return in the OTM write and can seriously boost the assigned return. When the stock really is moving strongly, many times the leg-in writer simply will elect not to write a call at all but simply profit from the stock’s price movement.
Figure 6.3 following assumes we buy the stock at $20 and compares writing the 22.5 Call immediately when the stock is bought for $20, versus legging in and writing it days later when the stock has risen to $21.50:
Comparison: Legging-In and Buy-Write
|Timing of Call Write||22.5 Call Premium||Uncalled Return||Called Return
|Immediate write at $20 (18.75 debit)||$1.25||6.67%||20.0% ($3.75)|
|Legging-in at $21.50 (17.60 debit)||$2.40||13.64%||27.8% ($4.90)|
The leg-in nearly doubles the uncalled return in our example above from $1.25 to $2.40, and yields a nearly 40% increase in return if assignment occurs (20% to 27.8%). Note that in both examples assignment at $22.50 brings in an additional $2.50 in profit. Legging-in is somewhat speculative, admittedly, because it leaves the investor without the immediate call premium and its risk-reducing benefits. But otherwise, the leg-in is no riskier than the buy-write. As with any OTM write, the stock may move up but by an insufficient amount to result in assignment; in this case a profit still is realized upon sale of the stock.
The additional advantage of legging in is that if the stock starts pulling back, 1) there are no short calls to close (and thus no cost to close them), which allows a traditional stop order, and 2) you can get out of the trade in the after-hours market, because there are no short calls preventing sale of the stock (calls cannot be repurchased in after-hours trading). And if you are not allowed to write naked, then you cannot sell the underlying stock in a covered call position in the after-hours market.
The leg-in writer, like the OTM writer, needs a good reason to expect an advance in the stock before expiration. If the stock already is advancing, so much the better; implied volatility will be high, thus premium will be good in either event: it will be even better if you leg in and sell the calls at a higher price. And also as with OTM writing, the legging-in technique works well with down-day writing.
Blended (Mixed) Writing
The stock price does not always fall conveniently where we would like it in relation to available strikes. However, not all the calls written must be the same strike. For example, assume that we buy the stock at $47.50 when these returns are offered as shown in Figure 6.4:
Blended Writing Comparison
Stock = $47.50
|Net Premium||Flat Return||Called Return|
|NOV 47.5 C (ATM)||45.75||1.75||3.8%||3.8% ($1.75)|
|NOV 50 C (OTM)||46.25||1.25||2.7%||8.1% ($3.75)|
The table above assumes we wrote an equal number of 47.5 Calls and 50 Calls. The ATM 47.5 Call write provides the best flat return, the OTM 50 Call write the best called return. But the blended write performs well both flat and called, which is why investors create them. The $1.50 blended premium is obtained by adding 1.25 to 1.75 and dividing by 2. The blended return called is obtained by adding the 1.75 ATM premium to the 3.75 from being called on the 50 Calls ($5.50 total) and dividing by 2.
Ah, but look at what happens if the stock finishes in the middle at $49: we keep the $1.75 premium from writing the 47.5 Calls and sell those shares upon assignment. But we pick up an extra $1.50 when we sell the remaining shares at the now-higher $49 price, meaning that we received $1.75 in premium on half the shares and a return of $2.75 on the other half (1.25 + 1.50); an average return of $2.25 per share on all the shares (2.75 + 1.75 ÷ 2). Our total return then is 4.9% ($2.25 ÷ $46) – a nice improvement over simply writing all the shares at the ATM 47.5 Call strike. Had the stock not advanced above the $47.50 purchase price, the blended write would have yielded a lower return than writing all ATM calls – but better than writing all OTM calls.
Therefore, the blended write only outperforms an all-ATM write if the stock at least moves above the entry price level, but that is true of all-OTM writes, as well. The blended write involves two separate commissions to write the two different call series, remember, so it is practical only with brokers offering the cheapest option commissions.
Lastly, if this seems a little advanced, check out options trading basics, which will cover calls and puts as well as the benefits of options.
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