best covered call strategies

Covered Call Strategies

Covered Call Strategies for All Market Conditions

Covered call strategies are popular with options sellers due to their capacity to generate regular income over time. In markets that rise or trade sideways, the call option premium supplies the income, and in falling markets, this same premium offsets the losses. Investors have used covered calls for more than 30 years. They’re so popular that in 2002 the Chicago Board Options Exchange released the first major benchmark index for covered call strategies – the CBOE S&P 500 BuyWrite Index (code BXM).

To make the best returns from covered calls, it’s generally necessary to apply them to stocks and shares with a much higher historical volatility. Although this appears somewhat counter-intuitive, research has revealed and even Warren Buffett has commented, that there is “no correlation between beta and risk”. The key reason why these volatile stocks can be so appealing is that they’re able to return 40%+ per annum – not necessarily because the stock price is going to rise dramatically but because the inflated option prices reflect the expectations for underlying stock volatility.

But covered call strategies also carry a measure of risk so we need to apply the right approach to different market conditions. The worst case scenario is when you purchase a stock, then write out-of-the-money (OTM) covered calls above the purchase price but the same stock price takes a big dive soon after. In cases like this, the option premium you have just received will probably not cover the capital loss on the shares themselves.

So what can you do?

Your original sold OTM calls will be significantly devalued by now, so you could buy them back ‘for a song’ so to speak and then sell more calls at a lower strike price. This would bring in further premium to offset the capital loss on the shares. But if you’re relying on covered call strategies for a regular income you won’t be making anything on those shares this month and if the price continues to decline, you may even have to take a loss.

So while writing OTM covered calls is great for a sideways or bullish outlook for a given share, it may not be the best idea when they are near their price peaks. You could purchase protective OTM puts at strike prices below the share purchase price but this would lower your overall income. Protective puts are a better strategy if you’re more “investor” than “trader” minded and plan to hold the shares for some time.

Neverthelss, in a bullish trend, OTM covered calls give the best outcome – you receive option premium plus a capital gain on the shares themselves. But for this strategy to work, you should use the best research tools to increase the probability of success. In this regard, the MarketClub SmartScan tool in combination with their proprietary “Trade Triangle” filtering and ranking service, can give you a shortlist of top stocks whose market values are most likely to rise in the near term. For only $8.95 for the first month – it’s worth a test-drive in my opinion.

Covered Call Strategies in a Bear Market

If the market as a whole has turned bearish, or you’re a very conservative trader and want to stack the odds in your favour, you can still make a regular income with the right covered call strategies. In this case, the best alternative is to sell IN-the-money call options over your shares. The intrinsic value in your sold call options will work in your favour should the underlying price fall. If these options become OUT-of-the-money you will be able to buy them back for a much cheaper price than you sold them for, thus making a profit. In the meantime the extra premium you have received will provide a much greater buffer against falling share prices than out-of-the-money premiums.

Once the share price has fallen significantly (but not as low as your ITM call option strike price) you ‘buy to close’ the sold options and immediately sell MORE in-the-money calls at a still lower strike price. The profits you make under these conditions are from the ‘time value’ of the options, which if prices have become volatile may also include some decent implied volatility to increase your returns.

And Sideways Markets

If you’ve observed a share price which is stuck in a narrow range and unlikely to move much either way in the short term, it’s very likely that option prices will be cheaper due to low implied volatility. This will reduce your income, which is what you exchange for lower perceived risk. For stocks like these you should consider writing AT-the-money call options over the stock. You will receive more premium than for OTM calls and since the stock price isn’t really going anywhere, you just ‘rinse and repeat’ each month until things change.

You can search for these type of stocks using a good stock and options screener, which most reputable brokers include with your account.

Bottom Fishing Stocks

We have dedicated a whole page to this subject, but the basic idea is, that you locate a solid company stock whose price has plummeted recently following an unfavourable news release or earnings report. You buy the stock at a discount by selling naked puts under it. Once you own the stock, you wait for the price to rise and then sell at-the-money or slightly out-of-the-money (depending on Implied Volatility) call options for income.

Making consistent returns from covered call strategies is simply a matter of deciding what risks and returns you’re comfortable with and then applying the appropriate method.

Covered Call Options

Covered Call Options – Using Margin Loans

Covered Call Options offer potential investors a low risk way of option trading in such a way that, if done correctly, can easily provide a regular income stream for the rest of your life.

Self education is freedom!

But did you know that if the funds that you have in your brokerage account are also connected with a margin loan, you can effectively double the profits from covered call options that you would otherwise receive if you didn’t use this facility.

What is a Margin Loan?

A margin loan is one of the few loans that you can easily access without any credit checks or formalities that usually go with getting a loan. The reason is, because it’s a loan that can only be used to purchase shares – and the shares you purchase in turn become collateral, or security, against the loan you will receive to buy more shares.

This is how it works.

Let’s say you start with $20,000 in your brokerage account and wish to buy shares with it. Your $20k will allow you to buy 800 shares currently trading at $25 per share. These 800 shares in turn become security for a lender, who is prepared to lend you another $20,000 to buy another 800 shares at the same price. So now you own 1,600 shares, 50 percent of which are from borrowed funds, the other 50 percent from your own money. You pay interest on the borrowed portion at the going interest rate.

This is why getting a margin loan is so easy to get and requires no credit checks, income statements or other ‘hoops’ you are normally required to jump through to get a regular loan. There is enough security in the assets (shares) themselves to cover any default on the loan – and if any problem arises, the broker can quickly liquidate your assets (sell all your shares) and close out the loan. Much easier than trying to repossess your car or sell your home.

Most margin lenders will have a ratio that they are prepared to lend you on any given stock. The ‘blue chip’ stocks usually carry a margin of around 65 percent or more, which effectively means that if you use the maximum margin available, you can increase your shareholding by 130 percent. But if you do that and the stock price suddenly falls, you will get a “margin call” from your broker, requiring you to top up your account with more funds to cover the increased risk, otherwise they will liquidate your stock.

This is why it is always best to use less than the maximum margin available. It gives you a buffer should the price fall. I would recommend using a 50 percent margin, which allows you to increase your shareholding by 100 percent – in other words, double it.

Covered Call Options and Margin Loans

Writing covered calls involves selling call options over shares that you already own, or have just purchased. For more information about covered call options, go to the main contents page and scroll down to persuse the various topics on the subject.

The call options you sell are ‘covered’ by the stock you have purchased. We say ‘covered’ because selling options (as opposed to buying them) exposes you to unlimited risk, should the underlying stock price move strongly against your anticipated direction. Selling call options means that you promise to allow others to ‘call’ on your to sell shares to them at an agreed price. So can you imagine what it would be like to have to go to the stock market and purchase shares in order to sell them at $20 when the current market price to buy them has risen to $40? The higher the share price goes, the more you are “exposed” to financial loss. This is why it is called selling “naked” call options.

But if you already own shares, then your potential loss is limited to the difference between the call options strike price and the price you paid for the shares. Hence the name, “covered call options”.

Now, getting back to the matter in hand. Selling covered call options allows you to receive an income from the shares in addition to dividends. If you are trading on the US exchanges, then each option contract covers 100 shares, so in our example above, you could sell (sometimes called ‘going short’ or ‘writing’) 8 call option contracts on 800 shares.

But if you could add to your $20,000 capital a further $20k using a margin loan, so that you now own 1,600 shares, then you are in a position to write 16 covered call options contracts and double your income.

If you combine this with another put option strategy we have discussed elsewhere, allowing you to purchase your shares at a discount, you can earn even more option income and lower your overall risk at the same time.

Covered Call Writing Strategy

Covered Call Writing Strategy For Compounding Monthly Income

You may have heard that the best covered call writing strategy is ideally suited to stocks which have good fundamentals and are on the rise. Let’s assume you have adopted a strategy to write “out of the money” call options immediately after purchasing multiples of 100 of any U.S. ‘optionable’ stocks. There are 3 possible outcomes:

1. The stock remains below the strike price but doesn’t fall significantly, by option expiration date
– AVERAGE OUTCOME … you keep the call option premium and possibly make some gain on the shares if you choose to sell them

2. The stock is above the strike price at option expiration date
– BEST OUTCOME … you keep the call option premium PLUS enjoy a gain on the shares if and when you are called to sell them

3. The stock falls significantly below the strike price by expiration date
– WORST OUTCOME … you keep the call option premium and use it to offset the loss on the shares

It will be obvious from the above, that our most favourable covered call strategy would be to sell call options at a strike price above our purchase price for the stock, then enjoy the satisfaction of selling the shares for a gain within the near month expiry period of the options. Then just do it all again . . . .

Covered Call Writing Strategy – Selecting Stocks

You can still make a monthly income using another covered call strategy suited to a bear market. We will consider that in another article. For now, let’s focus on picking stocks that are most likely to either rise or remain in a tight trading range in the near term.

To do this, we need to be aware of a couple of positive technical indicators. The first is the 50 day Exponential Moving Average (EMA) in connection with the 200 day EMA. When the 50 has crossed above the 200, this is generally considered by the charting world to be a sign that the stock is experiencing a “bull run” trend and tells us that the covered call writing strategy we should be interested in, involves writing “out-of-the-money” … “at-the-money” or slightly “in-the-money” calls – depending on the percentage yield each alternative offers us.

We want a call option premium which is at least 10 percent of the current market value of the underlying stock. If we can get this using out-of-the-money options we will be happy, otherwise look at ‘at-the-money’ etc.
We prefer options with a higher than normal Implied Volatility, but not at the expense of positive stock fundamentals.

In order to apply this covered call writing strategy quickly, a good covered call screener would help to bring up relevant data. The “options dragon” at OptionsXpress is an excellent free tool in this regard – but you have to be using them as your broker to access it. A better one can be found as part of a MarketClub membership. It costs around $50 per month once your $8.95 first month trial has expired, but the outstanding tools you receive in return should make you far more than that.

Having located stocks where the 50EMA has crossed above the 200EMA, you then draw trendlines over the top and bottom of the ‘highs’ and ‘lows’ to get a feel for where your stock is in its trading cycle. This will help you with timing of your entry. If the 50EMA has crossed below the 200EMA, you should consider a more conservative ‘bear market’ covered call writing strategy. We will outline these later. You should also look at the RSI technical indicator and determine whether the stock is near the upper (70) or lower (30) area. If above 70 it may be “overbought” and you should stay out. But if near the 30 “oversold” level this is a good indicator of future positive movement.

But back to rising stocks … we want to stack the odds in our favour for a near term positive stock movements even more. A great tool to use is the Investor’s Business Daily (IBD) service. It is limited to the USA stock market and again, there is a monthly membership fee.

This is what you do – membership with IBD will allow you to use their IBD Power Tools to scan the entire U.S. market for stocks with an ‘Earnings Per Share’ in the top 25 percent of all stocks trading on U.S. exchanges. You include in your search criteria, a 12 month Relative-Strength Ranking in the top 25 percent (not to be confused with the RSI indicator here – it’s IBD’s own terminology). These two important fundamental performance indicators, together with the technical indicators mentioned above, will ensure confidence in your covered call writing strategy.

Having established all positive indicators for your chosen stock to either rise or remain neutral during the near month option expiry cycle, you then check that the premium offered will meet your yield criteria and if acceptable, place the ‘buy-write’ trade. There is great advantage in using only ‘near month’ option expiry dates over ‘later month’ ones. During the last 30 days of an option’s life, it’s ‘time value’ declines at an exponential rate. Since you are a “seller” not a “buyer” of call options, you want to take advantage of this.

So … to summarize your best covered call writing strategy:

1. 50EMA to be above 200EMA if trading aggressively (per this strategy) otherwise trade conservatively.

2. Call option premium at least 10 percent of current market value of underlying stock

3. RSI technical indicator does not indicate “overbought” at time of entry

4. High implied volatility is good, but not at the expense of positive fundamentals. Stay away from tech stocks and drug companies – they are too unpredictable.

5. To add that edge of confidence, use the Investor’s Business Daily Online service to scan the markets for (a) EPS in top 25 percente of all U.S. stocks, and (b) their Relative Strength Ranking in the top 25 percent also.

If all the above features come into play, there is but one thing left to do . . . . . GO FOR IT!