To recap points made above, covered call writing is an ancillary strategy when the investor’s primary purpose is to profit long-term from ownership of the stock (stock investing) and calls are written against the portfolio stocks in order to produce income from them. Covered call writing is a primary strategy when the trader regularly buys stocks for the express purpose of writing calls on them; this is also known as the total return approach. Let us revisit our two main strategies.
Portfolio Writes (Overwriting)
This is the practice of writing calls to generate income on portfolio stocks held for investment. Most buy-and-hold investors don’t write calls on their stocks. More’s the pity, because writing calls on them would seriously augment returns from dividends and price appreciation (a “return” only if you sell the stock).
Selling call options on stocks already in the trader’s portfolio is a well-known method of increasing portfolio returns. Portfolio writing stocks creates a number of important advantages compared to simply holding stocks for future appreciation and dividends:
- It produces a regular income from stocks.
- The return is significantly higher than from merely holding the stocks.
- Overwriting reduces risk approximately one-third.
- Overwriting produces much higher returns in declining markets.
According to the Chicago Board Options Exchange (CBOE), which created the CBOE S&P 500 Buy Write Index (BXM), writing covered calls enhances returns and significantly reduces risk. More importantly, it turns a passive investment into an income-producing investment.
It has been noted that for over 100 years, the stock market has – on average – consistently gone up approximately 7-9% annually. However, there have been long periods of bear markets or price stagnation. Although a strategy based on fundamentals analysis, there clearly is a timing aspect even to plain old stock investing.
Moreover, the true time horizon for many investors is a period of 10 to 25 years, from the time they have meaningful money to invest to the point they begin to need money in retirement. There have been many periods of 10 years or more in which the market performed woefully. In fact, if one bought stocks in 1929 right before the crash, they did not regain their 1929 price until 1954, merely 25 years later.
No one is suggesting that stock investing does not work; clearly it can. But it is not an automatic path to wealth. Traditional stock investing relies on continuing investments over years, but also a rising market. How can a stock portfolio’s value grow except if the stocks rise in price (or split and rise)? They cannot.
Many people choose stocks poorly, betting on a market or technology that fizzles out. Some simply get into the stock market at the wrong time, and watch their stocks stagnate or founder.
Portfolio writing allows the stock owner to, in effect, collect a monthly special dividend (the call premium) on the shares. This augments declared stock dividends and, in the case of non-dividend stocks, creates an income from the stocks that was lacking. Even a return that averages only 1% a month would add significantly to overall returns over time and beat the average annual S&P 500 return by a landslide. We explore portfolio writing in depth further on.
The Basic Buy-Write
The trader writes call options against stock purchased expressly for that purpose. Generating a return from the call write is the writer’s primary strategy. The buy-writer is primarily an income investor, not a trader or speculator, though many of them trade in order to increase returns. Buy-writers are in the business of generating cash flow from their investments and thus are not “investors” in the same sense as buy-and-hold investors. That is, covered writers wring income from stocks on a regular basis, as opposed to holding trades long term in hopes of profiting from price appreciation.
When the covered call strategy is mentioned, it almost always refers to buy-writing. The goal is not investing through holding stocks long-term, but instead income investing: employing stocks as revenue-generating assets. A buy-write is simplicity itself, because the investor’s goal is to:
- Buy value stocks,
- Write calls on them, and
- Sells the stock to lock in the return, or make a larger return
Selling call options produces income on the shares. The shares thus are essentially an asset purchased for the purpose of generating an income. The only fly in the buy-write ointment is the stock that pulls back or, worse, sells off; leaving the trader with the choice of selling the stock at a loss or holding the stock in hopes of a recovery. Of course, there are trade management strategies to deal with dropping stocks, discussed later on, but no one has yet invented the stock that cannot fall in price.
Thus the buy-writer’s strategy is to buy the stock, “cream” it for premium and get out with an acceptable profit. The point is to generate a consistent income in which losses are few and small. This is possible only if the trader is disciplined in the four main components of covered writing, discussed below.
Conservative Covered Call Writing
Buy-writing is a strategy involving regular trades, each expected to generate a return of a few percent. Unlike the speculative, directional trader – who hopes for large returns on each short-term trade and thus accepts a high percentage of losing trades – the covered call writer receives a much smaller, defined return. The covered writer does not have huge returns to offset occasional large losses and thus must take steps to avoid or minimize losses. But that is easier than you might think, as we shall see.
Here are the practical elements of my method for achieving consistent success at systematic covered call writing, without significant account draw-downs:
Conservative Covered Call Method
|1. High Premium||
Premium returns that are too small do not reduce trading risk very much, and commission costs will be too large in relation to returns. You and only you decide what is “high” enough.
2. Trade Selection
|The writer must employ a strategy designed to select trades offering an acceptable return, a high probability of success and a lower risk profile. Poor trade selection will lead to too many losing trades (and losses that are too large) to allow consistent success.|
3. Trade Planning
|The writer must plan and design the trade with reference to the stock chart. Failure to plan leaves money on the table and exposes the writer to needless risk. But to trade the plan, you first need a plan.|
4. Trade Management
|Trade management can dramatically increase returns or mitigate potential losses. The call writer must be prepared to manage the trade when necessary in order to maximize profits or to minimize loss. Many times a loss can be avoided if the trade is managed properly.|
These may seem like “duh” points, but it is amazing how many people exhort the public to write covered calls by simply finding the stocks with the highest returns and let lead fly. Yet this is precisely why so many people get burned at covered calls.
I’m serious as a heart attack about this. Whenever I look at call writers’ occasional losing trades, I typically find that about a majority of losses result from poor trade selection. The remaining losses result from poor planning or management – or no management at all. For example, when the market corrected in May 2006, March 2007 and July 2007, many covered writers found themselves in dropping positions. Some of them panicked and closed for a loss. Many times the losses resulted from writing weaker stocks, which were hit hardest and didn’t recover as well as the market, which soon came back to new multi-year highs and, in the case of the DJIA, to all-time highs. Those who managed their trades properly and didn’t panic did quite well.
Not everyone agrees that trade selection is so important. And many do not believe that planning and management are important. But as we will see in succeeding articles, they are inextricably part of consistently successful call writing.