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Writing Covered Calls on Market Down-Days

One strategy to deal with the current market turmoil is called down-day covered writing.  This is based on looking for stocks that are down on a day that the market is down.  This strategy assumes the rubber band reaction of the stock bouncing back up when the market move up. This gives the writer the advantage of buying the stock at a cheaper price than on a market up-day.

On a day with a big pullback, you are trading a lower premium for the potential capital gain of the bounce back price.  For example, a stock is trading at $45 and the current month 45 call is priced at $2.10 indicating a cost basis of $42.90 and a assigned return of 4.9%.  However, on the market down-day, the stock drops to $43 and the 45 call price drops to $0.90.  If you enter this trade by buying the stock at $43 and selling the 45 call for $0.90, your cost basis is now $42.10 and your assigned return is now 6.9%.  If the stock falls short of $45 at expiration, you keep the $0.90 in premium and write a new 45 call at the next expiration date.

Example of covered call on market down-day

Click to enlarge

 

 

The key to this strategy is making sure the stock is trading with the market.  Here we will define the market as the S&P 500.  Use a chart service such as bigcharts to create a chart with your stock.  Then click the compare buttom to add the SPX (S&P 500).  See chart below of ESRX compared to SPX.  You should notice that the stock and SPX have a very similar pattern.  If yes, the two are moving in lockstep together and this is a good candidate for this strategy.

This strategy is not about the technical movement of the charts but about the potential snap back movement of the stock.  This serves as an example of why covered call traders sell out-of-the-money (OTM) calls to increase return on investments.

Stock Chart comparing SPX price movement to ESRX.

Click to enlarge

How to Get Started With Writing Calls

How do you get started with trading covered calls?  Once you understand the principles of writing options, you must determine what stock to purchase for this trade.  The simplest method is to start with a list of stocks.  I suggest the S&P Dividend Aristocrats list.   Since this trade requires buying stock, why not get paid a dividend in addition to the call premium.  This is more effective when you continue to write calls on the stock month after month until you are assigned.  This gives you a second dividend income to increase your monthly income stream.

The S&P 500 Dividend Aristocrats is currently a list of 42 companies that have increased dividends (not just remained the same) for 25 years straight.  Keep in mind just because they are on this list now, doesn’t mean in the future they will be forced to reduce their dividend.  Unfortunately during our last recession in 2008 many investors found out their dividend was cut on their once stable stock.  For example, Pfizer Inc. (PFE) and General Electric Company (GE) both cut their dividend, and were removed from the Dividend Aristocrat list in 2009.  In 2009 a total of 10 companies were removed from the list.  As you can see from the list of stocks, these aren’t exactly a list of highflying tech stocks like Apple (AAPL) or Google (GOOG). In fact most people consider these stocks boring, but boring is sometimes better.

The list below shows the stocks included in the Dividend Aristocrats list for 2011.  You should start looking at the company’s with a 4 or 5 star rating by Standard & Poors.  You can find a level of ease when a stock is rated a strong buy or buy by S&P.  There are 5 stocks rated strong buy on the list: XOM, WMT, KO, PPG, and VFC.

Company Name Symbol Price PE Yield % SP Rating SP Recommend
Exxon Mobil Corp XOM        85.22 12.1 2.2 5 Strong Buy
Wal-Mart Stores WMT        54.52 12.7 2.7 5 Strong Buy
Coca-Cola Co KO        69.73 13.0 2.7 5 Strong Buy
PPG Industries Inc PPG        88.94 14.0 2.6 5 Strong Buy
VF Corp VFC      120.50 21.1 2.1 5 Strong Buy
Chubb Corp CB        64.45 9.1 2.4 4 Buy
AFLAC Inc AFL        46.21 10.4 2.6 4 Buy
Target Corp TGT        51.81 12.6 2.3 4 Buy
Abbott Laboratories ABT        52.95 12.7 3.6 4 Buy
Dover Corp DOV        66.84 15.0 1.7 4 Buy
Walgreen Co WAG        40.02 15.6 2.3 4 Buy
Johnson & Johnson JNJ        66.72 16.0 3.4 4 Buy
PepsiCo Inc PEP        65.76 16.7 3.1 4 Buy
Becton, Dickinson & Co BDX        87.16 16.8 1.9 4 Buy
Grainger, W.W. Inc GWW      155.45 18.5 1.7 4 Buy
Brown-Forman Corp B BF/B        75.96 19.5 1.7 4 Buy
Stanley Black & Decker SWK        70.10 19.5 2.3 4 Buy
Leggett & Platt LEG        23.50 20.3 4.6 4 Buy
Cintas Corp CTAS        34.37 20.5 1.4 4 Buy
Automatic Data Processing ADP        53.23 21.7 2.7 4 Buy
Sigma-Aldrich Corp SIAL        73.53 22.4 1.0 4 Buy
Archer-Daniels-Midland Co ADM        32.12 10.0 2.0 3 Hold
Cincinnati Financial Corp CINF        28.40 12.5 5.6 3 Hold
CenturyLink Inc CTL        38.66 13.0 7.5 3 Hold
Consolidated Edison Inc ED        53.58 14.4 4.5 3 Hold
Pitney Bowes Inc PBI        22.41 14.6 6.0 3 Hold
Kimberly-Clark KMB        67.90 15.4 4.1 3 Hold
Lowe’s Cos Inc LOW        22.62 15.9 2.5 3 Hold
3M Co MMM        95.38 16.4 2.3 3 Hold
Bemis Co Inc BMS        33.95 16.7 2.8 3 Hold
Procter & Gamble PG        64.25 16.9 3.3 3 Hold
Air Products & Chemicals Inc APD        91.90 17.2 2.5 3 Hold
McCormick & Co MKC        50.25 17.5 2.2 3 Hold
Family Dollar Stores Inc FDO        54.14 17.9 1.3 3 Hold
McDonald’s Corp MCD        88.56 17.9 2.8 3 Hold
Emerson Electric Co EMR        55.10 19.2 2.5 3 Hold
Ecolab Inc ECL        53.05 23.8 1.3 3 Hold
Bard, C.R. Inc BCR        99.28 26.9 0.8 3 Hold
Clorox Co CLX        74.36 39.4 3.2 3 Hold
Hormel Foods Corp HRL        30.29 17.7 1.7 2 Sell
Sherwin-Williams Co SHW        79.64 17.4 1.8 1 Strong Sell
McGraw-Hill Cos Inc MHP        43.92 16.1 2.3 NA NA

Trading Covered Calls by Legging In

This strategy is a variation of the out-of-the-money (OTM) covered call strategy.  When you are anticipation a market upturn such as a bounce up or your stock is in a prolonged uptrend, this strategy may work for this type of situation.  The legging in strategy is to buy the stock and then wait for the price to increase before selling OTM calls.  The legging in is related to the buy the stock (one leg) before you sell the calls (second leg) at a later date to complete the covered call trade.

This strategy can significantly increase your returns when the stock price moves up rapidly.  Then, you have a decision to make about when to sell the call.  Some traders decide that the stock will continue to rise so they do not sell the call.  Others may decide the stock is out of gas to move higher so they will
sell an OTM call for additional income.

As an example, you may purchase a stock at $52.40.  The current month 52.50 call strike is selling for $1.00.  You can buy the stock at $52.40 and sell the 52.50 call for $1.00 and get an unassigned return of 2.14%.  You don’t want to lock in your covered call trade for a low return so you wait on the stock.  To leg in to this trade, you would buy the stock and wait until its price increases to around $54.00.  At this time, the 52.50 call strike price is $2.50.  The leg in trader
would sell the 52.50 call strike if the stock was out of momentum and poised for a pullback.  This would create an assigned return of 5.01%.  This return is more than double the initial trade with a downside protection to $52.50.

The leg in trade more than doubles the unassigned return because the option premium more than doubled (from $1.00 to $2.50) as the stock price increased.  The return percentage doubled while both trades were at the same strike price (52.50).  This could be even better if the trader moves their call strike price
to 55 to let a stock continue to run up to a higher price.

So what is the trade off for the additional return?  Legging-in is a little speculative because it leaves the investor without a premium for a short time
while waiting for the stock price to increase.  Additionally, the trader does not have the downside protection while owning only the stock without selling the
call.  Lastly, the investor could be wrong and the stock never increases in price.

The bottomline is that the trader must have a solid reason for why the stock will increase in price in the short-term.  the moment this rationale is proven wrong, the trader must make a decision on how to proceed with the stock they own.

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When To Take Action with Covered Calls

The basic covered call trader will write a call and wait until it expires then decide what action to take next.  I suggest that you monitor your position and determine what changes to make before expiration to enhance your profit or decrease your downside risk.

For the call writer with less time who does not have the time to monitor the position, you have 2 options to negotiate the market action:

  1. Determine the price you want to close the position and then set an automatic stop order.  For example, you entered a covered call and you do not want to let the stock decline so you enter a stop order to but the sold option at market and then sell the stock with both events triggered by your predetermined stock price.
  2. Let the option go until expiration and then make your next move.  This strategy does not mean you will lose money but you will keep selling calls to minimize any stock price decreases over time.

Now, for the more active covered call trader, here are 2 actions to increase your trading profits:

  1. If the price of any option you sold declines to a small amount, then buy the option back to lock in profits on the option.  If the option price drops to 25 cents per share or less, then you can buy it back with the different between sold option price being a profit.
  2. The second option is to watch the time value of an in-the-money option and buy it back when the time value gets low.  the rationale is that you have made most of the profit already as time value can only go to zero.  If there is only 10 or 20 cents left, you can buy to close and sell another option for more premium income.

There is no right or wrong strategy based on these two methods to trade covered calls.  You should decide if you fall into the first scenario (less monitoring) or the second (more activity) based on your time commitment to your covered call trades.  In a later post, I will discuss my way of trading covered calls based on a strategy that takes option obligation and stock price into consideration.

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Writing Out-Of-The-Money Covered Calls

If you are bullish on a specific stock, then you should consider writing an out-of-the-money (OTC) covered call.  This type of call includes a strike price that is above the current stock price.  You still get a call premium but is generally less than an at-the-money call.  But you also get the potential of stock appreciation because of the higher strike price of the call sold.  This creates a situation for potentially two income streams from one trade.

This trading strategy works best when you can confirm the stock being in an uptrend or if the stock is bouncing off a support level.  A support level would be something like a 50-day moving average or even a Bollinger Band that has been stretched on the bottom.

The key to this strategy is to be right about the stock price moving higher in the near future.  Due to the OTM call offering less premium than an ATM and having a low delta, they can be slow to lose value on a stock pullback.  This strategy should be used in special situations or during a slow moving bull market.

Also, you want to avoid this strategy when he stock has gapped up until the new price range is confirmed.  Stocks that gap up usually pull back before they stabliize in a new trading range.  However, a stock slowing moving up is a good opportunity for OTM writes.

This strategy works well when you have a down-day in the stock or market.  The stock price decline will usually be temporary down and will bounce back in a few trading days.  You need to be sure the market decline is not a permanent correction that will be sustained for months.

This is a good strategy for stocks you do not want called away in a flat market.  You can still get an increased profit if the stock price is above the entry price at expiration.  Then, you get an even bigger return if you get called out at the higher call strike price.

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Writing Deep-In-The-Money Covered Calls For Protection

The conservative covered call writer is seeking downside protection and income from premium.  This investor places more value on protecting capital and is not concerned about their stock being called away.  This covered call investor will sell calls that are deep-in-the-money (ITM).  This is a good strategy when the market uncertainty increases and there is increasing worry about a market correction.

For example, if XYZ is trading at $53.00 then a deep ITM call will be sold at the 45 strike price.  This call is $8.00 ITM and provides a 15% downside protection.  With a stable stock like XYZ, it probably will not go below the 45 strike price during a market pullback.  In fact, XYZ has not been below $45.00 in the last three years.

The trade-off for selling ITM calls is that the returns will be lower as the majority of the call premium is intrinsic value.  The method to the madness is that these calls offer more downside protection in return to accepting a lower time value of premium.  ITM call writes can be a very successful strategy when used on large-cap stocks during a martket pullback.

There are many covered call traders that suggests they made a higher return over a long time period for several reasons:

  • It is not that difficult to find a 3% return with 30 days remaining on high quality stocks;
  • The stocks will be assigned at expiration so you are never stuck with a stock that is down;
  • ITM calls have a higher delta so they lose value closer to the stock.  You can easily roll down your strike price without a loss;
  • Trading the short call is more profitable due to the high delta.  Here trading refers to buying back the call on a price dip and write them again on the bounce back.

The ITM writer should concentrate on large-cap, high quality stocks as there is never a reason to trade poor quality stocks regardless of your strategy with ITM calls.  The one item of note is that this strategy is not the best in a rising bull market unless you have a high risk avoidance to a potential trade loss.

A variation of this trade is to use it when volatility is high such as in the financial crisis in 2009.  The high volatility will increase the amount of premium and return.  You can use this strategy when there is a pending event such as an earnings release but not as a speculation trade.  the key is to use this strategy with large-cap, high quality stocks.

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Covered Call Strategies – Expiration Writing

There are many variations of the covered call trade.  The classic covered call is to select the trade, buy the stock and sell the ATM call.  In addition, there are a number of strategies that are variations of the classic call based on different trading ideas.  One covered call variation is expiration writing.

The investor will scan for short-term writes in the last two weeks of the current option cycle.  The trader is looking for stocks with high premium and high return on funds invested.  To get high returns over such a short time period usually indicates a high implied volatility and increased risk.  When IV is higher than actual volatility, then there is usually a pending event so you must research these trades very thoroughly.

One safer way to do this is to find a stock with higher volatility due to an event planned in advance.  Examine the stock to see when the event date is scheduled.  If the event will occur after the current expiration date, then you can trade in the current month calls.  The reason for this is that event volatility may increase premiums across both the current month and the next month option cycles.  This is a cool trick that most covered call writers had not heard of before.

This is not a risk free trade but it works if you are right about the timing of the event expiration being after the current month.  The key is to actually confirm the event date and not speculating about when it will occur.  Do not just go by the high volatility in two month alone as this does not indicate the event date.  If the IV is in line with the historical volatility, it may be a great covered call write anyway.

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How To Use Volatility in Selecting Covered Call Trades

If options were always fairly priced, then we would expect the option price to always imply a level of stock volatility that is more or less in line with historic volatility (HV).  But this not always the case.  For example, two stocks are trading at $20 each with current month calls at $20; one calls ask price is $1.00 while the other is at $2.00.  In comparison, one calls value is twice the others. Why? The difference is in implied volatility of the two stocks.

Implied volatility is the market’s perception of how volatile a stock will likely be in the future.  A covered call trader must understand how implied volatility affects their trading  decisions.  IV Can be the same as historical volatility, lower than historical or higher than historical.  What if an option has an implied volatility of 70% while the stock had a volatility of 25%?  The Black-Scholes calculation would tell us that the option is overpriced.

The key to covered writes: how implied volatility compares to historical volatility.  When option volatility (call IV) is lower than the 10-day/30-day historical volatility, then the call option is under priced.  For call writers, under priced options mean you are not being paid for the stock’s actual volatility.  However, if the calls IV is extremely higher than historical volatility, the market is expecting something to happen.  If after the event the IV collapses then the calls value will collapse.  But…

You should not chase the high IV because those stocks are too risky.  You should compare IV to both the 10-day and 30-day historical volatility.  This will tell you if the the IV is in line with HV.  Generally, you do not want IV to be significantly higher (10-15%) than either 10-day or 30-day historical volatility.

 

The rules are as follows:

  • If IV is higher than HV – then an event is projected such as news, earnings, etc. Find another stock to write calls on;
  • If IV is lower than HV – then the option is likely under priced so you should Find another call write trade;
  • If IV is in line with HV – then this is a good trade if stock volatility is below 40%.

For conservative covered calls, you want stock volatility below 40%.  Any stock with a volatility above 60% is too risky for a covered call trade.  

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Using Put-Call Ratios in Covered Call Trades

The Put-call ratio is a market sentiment statistic that has been around for quite some time and are followed by option traders.  This stat is based on open interest for each option strike price.  A put-call ratio is the number of put contracts divided by the number of call contracts open.  An increasing ratio is a clear indication that investors are starting to move toward instruments that gain when prices decline rather than when they rise. Since the number of call options is found in the denominator of the ratio, a reduction in the number of traded calls will result in an increase in the value of the ratio. This is significant because the market is indicating that it is starting to dampen its bullish outlook.

You can use these ratios when considering the strike price of the option that you are considering selling.  If there are more open calls than puts, you sell the strike price higher than current stock price as the indicator is showing a bullish sign.  If there are more puts, you should sell the stock price lower than the current stock price as this indicates a potential bearish move.  The ratios are influenced by option speculators who are gamblers, not stupid, very wise and putting up real dollars to back their options.

The put-call ratio is a true indicator of option market sentiment.  You can rely on the put-call ratio continuously because it is very reliable.  Recall that the idea of contrarian sentiment analysis is to measure the pulse of the speculative option crowd, who are wrong more than they are right. We should therefore be looking at the equity-only ratio for a purer measure of the speculative trader. In addition, the critical threshold levels should be dynamic, chosen from the previous 52-week highs and lows of the series, adjusting for trends in the data.

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8 Ways to Profit from Covered Call Trades

The covered call trade has always been known as an income strategy as you receive premium for selling calls against your stock.  This is the most popular rationale for implementing this type of tradings.  However, there are many more dimensions that can be coupled with covered call trading to further enhance the potential for profits.  Here is a list of 7 methods to more profits writing covered call trades.

  1. Selling the classic covered call against stock you own.  You make money with the time decay of the short call.  usually you sell the near month or next month out so you can continue to compound your money.
  2. You can use LEAPs as stock replacement to leverage a covered call trade which will increase potential profit returns.  Click here  for a recent article on this topic.
  3.  You can sell out-of-the-money (OTM) calls as your short call.  Here you get the call premium and potential for a capital gain as the OTM call offers some upside profits for the stock price to increase.
  4. You can make more money on a short call when volatility collaspse early in the trade and you close the trade.  We have all been in covered call trades when after a few days the call option loses value and you find yourself in a very profitable trade.  You can close this short call to lock in profits.
  5. You can trade the short call as the stock price changes.  For example, if the stock price decreases, you can close the short option early for a profit.  Then, the call can be written again when the stock prices snaps back to higher levels.  This is similar to channeling stocks by trading the short call against stock price changes.
  6. You can roll up or roll out the short calls to a higher strike price or to a later expiration month.  This allows you to squeeze extra profits out of a stock price rise.
  7. You can add option legs to a short call to create spread positions such as a bull or bear call spread.  This is good to take profits from a rising covered call trade or a falling stock price.
  8. You can add a long protective put to the covered call position as it will increase in value as the stock price decreases.  This is usually utilized as protection against stock declines but can create more income when a stock price declines while you are holding a covered call position.

It is not necessary to use all of these methods when trading covered calls.  It will be advantageous to the income trader to use more than one method to make money income from selling premiums.  In addition, some of these methods can be used to enhance and/or protect your monthly income.

Adding these methods does require more monitoring or your covered call positions.  The advantage is that it adds more potential for profits compared to the classic covered call trade.  It really comes down to how active you want to be in your income trading each month.

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