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Option Selection for Covered Call Writing

Throughout the day, a person makes hundreds of decisions.  Paper or plastic? Double cheeseburger or salad?  Home brewed coffee or Starbucks Brew to Order?  And for option traders, which option to select from a large list of strike prices and expiration dates.

Option selection can be difficult especially for the new option investor.  Do you play a short-term or long-term option?  Do you take risk with OTM options or play it safe with DITM options?  Don’t let the selection process get too complicated for you.  Follow these three questions when making an option selection:

  1. What direction will the underlying stock go in the future?
  2. What are your expectations for the stock?
  3. What is your risk tolerance?

For the first question, don’t just guess where you think the stock will go in the next few months.  Look at the put/call ratio on the open interest tables.  Are there more calls than puts?  This indicates that investors feel the stock will rise.  If there are more puts than calls, then investors feel that the stock is going to decline.  You can use the put/call ratio to help determine the future direction of the stock.

The risk is in selecting the strike price of the option.  You have three choices: ITM, ATM and OTM.  Which one works for your stock?  An ITM has the highest price as it has intrinsic value because the stock price is higher than the option strike price.  This intrinsic value provides a spread for the option, making it less risky.   An ATM is when the stock price and option strike price are very close.  Generally, the price of the option is all time value and it has more premium than an OTM option.  This is the middle ground on the option risk scale.  The OTM option is the riskiest option play.  The option writer gets less premium income and takes on the risk that the stock will move higher to get a better return.  However, when the stock price does rise, OTM options have the greatest return.  You probably have heard about the more risk, higher return trade.

Now, you need to select what time to sell?  The more time the more premium income.  Selecting the right time to sell is up to the option trader.  Regular options are up to nine months and LEAPS are for up to 2 years.  You must decide how much premium you want to receive based on how long you want the trade to be.  For covered calls, most writers select the monthly option and repeat until called away.  However, this should be based on the objective of the covered call writer.

Support and Resistance levels for the Covered Call Writer

One of the keys to covered call writing success is knowing how to determine support and resistance levels.  A support level is a stock price low that the price has hit and recovered from to advance back up due to more buying than selling of shares.  This is referred to as the trading floor until a stock price breaks below it.  The resistance level is a higher level that the stock price has hit and pulled back due to more selling than buying of shares.  This ceiling acts as resistance that the stock price must break through to advance higher.

The more times the price has hit a support or resistance level, the stronger it is and more difficult to move through it.  The longer it takes for the stock to test
these levels, the stronger they are to break through.  For example, an intraday test is not as strong as a one week test of these levels.  The higher the stock volume at the level, the stronger the level is holding.  For example, if volume is above average and the stock price doesn’t break out then the level will hold and be more difficult to go through.

Most technicians draw the support and resistance levels at the lowest and highest price points on a stock chart.  If stock price reached a certain support or
resistance level multiple times, you can safely disregard a single price spike above or below these levels.

How can the covered call writer use these support and resistance levels.  If a quality stock has successfully tested the support levels, then you know where the price bottom is for that stock.  You can also use the support level to tell you when to react as a break below support requires a new decision on what to do with your covered call – close it, roll out, etc.  The other use of support and resistance for the call writer is to delay entering a new trade when a support or resistance level is being tested.  These price points should be watched closely to see if they hold.  If they do not hold, then be prepared to make
a decision on managing the covered call trade.

How To Manage A Covered Call Portfolio

The option income portfolio approach to selling covered call options seek to do the following:

  • To create options portfolios with the objective of earning consistent returns on investment throughout the stock market cycle;
  • To maximize options premium income, dividend income, capital gains potential and downside protection;
  • To increase long-term capital appreciation and income from stock ownership;
  • To minimize risk and provide diversification.

The option income portfolio is a continuous investment strategy.  Stock should be owned and options sold.  Dividend and option premiums can be earned and capital gains increased.  This is a key step in successful investing.

The more active you are, the greater you potential returns will be.  For example, when a sold call’s market value drops to 10-20% of the call premium received when initially sold – the investor should buy to close the call and then write a new call for more time value and/or at a different strike price.  This makes the covered call strategy more continuous and more profitable.

The experienced covered call investor will not panic when the stock price exceeds their call strike price.  They will buy to close the sold call for a loss and sell a new call at a higher strike price.  The loss will be covered by the additional call premium and the potential capital gain of the increased stock price.  The loss from the initial call buyback is a taxable loss for your income tax statement.  The loss is calculated by subtracting the cost of the buyback from the initial call premium received.  The investor should always keep a running log of these buyback transactions that result in a trading loss for income tax purposes.
Like any losses over the allowable $3,000 in annual investing losses, they can be carried forward.

As an individual investor, you may not have time to manage a covered call portfolio like described above.  This is OK as you can still create a covered call portfolio for monthly income.  As you gain more investing experience, you can move in the direction of being more active in managing your covered call investing.

 

How To Use Moving Averages in Covered Call Selection

The use of moving averages are important to assessing the price trend of a stock.  Even better is using multiple moving averages to increase your accuracy of identifying the stock trend.  The definition of a moving average is the average of the stocks closing price over a period of time. As a new closing price is made, it is added to the calculation and the oldest closing price is removed from the calculation. This creates a new data point on the moving average as this process continues into the future.

The simple moving average (SMA) is the total of all closing prices for the time period divided by the number of points in the period. The exponential moving average (EMA) weighs more recent closing prices higher than older data prices as the newest data point is more relevant than older price points.  the EMA is more sensitive than the SMA but it has more frequent false signals.

I prefer to use the 20-day SMA and the 50-day SMA in my price charting.  There is nothing magical about these SMAs as other investors may use a 14-day and 40-day SMA.  I like the 20 and 50 day SMAs as a 20-day is 4 weeks or one month based on closing prices and the 50 day is 10 weeks. I usually sell the current month so the 20-day is more suitable to a one month call option while the 50-day serves as my longer term marker.

What should you look for in moving averages?  First, any time one SMA crosses the other the trend has changed (see chart below).  When the 20-day crosses ABOVE the 50-day, then the stock is starting an uptrend.  Conversely, if the 20-day crosses BELOW the 50-day the trend is moving down. The predictive factor happens when the stock price gaps way above the 20-day SMA as this signals a pullback for the stock.

The best covered call candidate will have the 20-day SMA above the 50-day with a flat or uptrending price line.  If the 20-day is below the 50-day, I usually pass on the stock as there are so many other stocks better suited to a profitable covered call trade.

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The Best Method for Call Writing

Most experts in the stock market will generally say, “the writer of an options is foregoing any increase in stock price that exceed the strike price for the premium received when selling calls.  The option writer continues to bear the risk of a sharp decline in the price of the stock. The cash premium will only offset this loss.”  Do you buy into this way of thinking?  This is not correct based on how I trade covered calls.

With my method, you no longer care about the price of the stock that you purchased.  When the stock does go down, we would buy back the option at an inexpensive cost and immediately write a new option.  For example, we received a premium of $3.00 and close it at $0.25 when the stock price drops.  If the stock price went down $5.00, we would write a new call at at a $5 lower strike price.  This may net an addition premium of $3.00 so when you add the premiums minus the buy back of the first option we have $5.75 while the stock only dropped $5.00.  The second premium helped to offset the loss from the strike price.

When the stock does not reach the strike price, let the option expire, keep the premium, and write a new cal at the same strike price.  When the stock price goes above the call strike price, buy back the call option and write a new option at a higher strike price to reflect the gain in the stock. the second premium will help defray the cost of the buyback while you have a gain in the stock price.

For the buyer, options are a wasting asset as time decay erodes value.  The time value portion of a option is always zero at expiration.  Selling the time value repeatedly on the same stock makes option income work for you.

With my trading method, you will not be waiting on the stock price to go up to make money.  You will make money on the wasting time value of options you have sold.  this will change your investing philosophy about the stock market.

Monthly Income Plan Newsletter

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Free Covered Call Trade on Yahoo (YHOO)

Covered Call Recommendation on Yahoo (YHOO)

STRATEGY:

Look at the November 2011 14 covered call.  For each 100 shares of Yahoo (YHOO) stock you buy, sell one November 2011 14 covered call option for a $12.30
(13.50 – 1.20) debit or better.  This is potentially a 13.8% assigned return.  Yahoo does not pay a dividend.

Blanket Put:  If you are looking for a blanket put for protection, look to buy the Apr 2012 13 Put for $2.00.  You will sell the Blanket Put when the covered call position is closed.
RISK  The technicals for YHOO are bullish with a weak downward trend.  The stock is under accumulation with support at 11.29. S&P rates this stock 4 STARS (out of five) – buy.

S&P research notes:

S&P reiterates Buy opinion on shares of Yahoo (YHOO) .  According to unconfirmed reports from Bloomberg and others, at a scheduled talk and Q&A session held late last week at Stanford University’s graduate business school, Jack Ma, the founder, Chairman and CEO of Alibaba Group, expressed an interest in buying YHOO. He referenced discussions with the company and other interested parties. We think that YHOO is considering strategic alternatives, and believe its 43% stake in Alibaba is perhaps its most valuable single asset.  Ma and Alibaba have been interested in repurchasing all or some of YHOO’s stake for some time.

The Blanket Put Strategy – Trade with Intel

One of the most important components to investing success is to protect your capital.  One big loss such as a stunning 50% in a single position will require a 100% gain to get your capital back to EVEN!  However, if you limit your risk to 5% or less in a single position then you can easily get your capital back to even on the next trade.  So how do you limit your risk exposure when trading covered calls?

The Blanket Put strategy allows the generation of real profits while limiting the amount of risk to just a few percentage points of the trade debit.  The Blanket Put is simply buying the stock, selling a call and then buying a long-term put.  This strategy is great for markets with high volatility and when there is uncertainty of future market direction.  The major focus here is to buy a CHEAP put so that you do not spend much of your premium on protection.  The Blanket Put is to ensure you get the Return of Your Capital.  We want to do this at the cheapest price possible as we are buying the Blanket Put.

Let’s walk through an example with Intel (INTC).  The table below shows the monthly results for the covered call with Blanket Put.  We buy 100 shares of Intel at $21.50 per share.  We then sell the next month 21 call at $1.25 for a net debit of 20.25 on the covered call.  To setup the Blanket Put, we buy the April 21 2012 put for $2.20.  This brings our total net debit to $22.45.  The Blanket Put has a strike price of 21 so we are guaranteed to be able to sale our INTC shares at this price between now and April 2012 expiration day.

We want to sell a 21 call for the next month until April 2012 expiration.  We have used 1.00 for the call premium each month but this can be higher or lower in the live trade.  After the Dec 2011 expiration we have a net debit of $20.45 for a guaranteed profitable trade.  In total, we will collect $7.25 in total premiums for a total return of 44% in only 7 months or 75% annualized.  This calculation excludes the dividends and trading commissions.

To manage the trade when you get called out on the covered call, you have two options: (1) buy back the stock and keep the put in place or (2) sell the put and start a new trade at the current stock price.  You need to keep in mind that INTC is a dividend payer so you get this payment each quarter.  Also, INTC is known for increasing their dividend so this stock is great for holding long-term in your portfolio.

 

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How To Use a Protective Put with a Covered Call

One of the basic mistakes that new covered call traders make is that they trade for the highest premium available to maximize their monthly income without looking at the amount of risk they are taking on with this type of trade.  When option premiums are high there is a reason for the increase in option pricing because of some uncertainty or increased risks.  The advanced covered call trader knows this and uses a protective put to manage their risk of loss on a high volatility trade.

The classic strategy is protect a position is to buy a put which is referred to as a “protective put.”  With a put buy you have the right (but no obligation) to sell a stock at the strike price of the put.  The protective put allows the stock owner to keep the stock but limits the amount of downsize to a lower stock price at the put’s strike price.  The stock owner no longer has price risk once the stock price falls below the put strike price as they can sell the stock at the put strike price before the option expires.
Stock investors refer to a put as price insurance as the cost of buying a put is similar to paying an insurance premium and the ownership of the put is
the insurance policy.  The management of stock price insurance is an additional cost to the trade.  For covered call investors, they must determine if it is worthwhile to buy the put as it will affect their monthly income plan.  The amount of buying a put depends on the amount of time before expiration, the strike price and the implied volatility of the put.  As you know, as volatility increases then option prices will tend to increase as well.

The table below shows an example trade with Under Armour (UA).  The stock is trading at $67.74 per share.  This example displays buying a put for protection at three strike prices: ITM, ATM & OTM.  As shown, the more in-the-money (ITM) the put then the more protection in stock price and less risk exposure in dollar terms.  The risk exposure is calculated by subtracting the put strike price from the net debit (share price + put cost).

The bottom two rows in the table show selling an ATM October call of 67.5 on UA.  You will receive $5.80 in premium for every call sold.  If you subtract this call premium from the risk exposure shown in the top portion of the table, you get the total risk exposure of the covered call with protective put trade.

Again – the more ITM the trade, the less risk exposure.  This example assumes the protective put strike price comes into play.  Of course, you would not usually use this strategy in a bull market as it is more effective during bear markets with increased levels of uncertainty.  You can also play what-if by using different
expiration months for the protective put.

How to use a protective put with a covered call

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