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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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How To Avoid the Option Premium Trap

Many investors get too excited while seeing the high potential return based on high premiums.  There is always a reason that a call premium is higher than normal.  It may be a fad stock, potential takeover target or expecting some news release that may affect stock price.  The time premium on these stocks is big making them tempting to write.  It is best to pass up these volatile stocks for more stable and fundamental stocks.  In call writing, your gains are topped but loses are not limited to just the net proceeds of the trade.

There is no option premium large enough to protect you from a big downside break.  When you hear stories of investors being wiped out in writing calls, it is usually because they were writing for fat premiums.  The basic rule is to stick to stable stocks that you would feel comfortable at the net price paid for the optionable stock.

The exchanges are filled with potential stocks to write calls on.  The best way to find candidates is through a process of elimination.  For example, start with a list of stocks ranked 5 stars by S&P.  Then eliminate those with a high volatility such as 50% or higher.  Then determine which stocks you want to own to sell calls on the stock.  Then you can diversify the stocks you select from different sectors and industries for more safety.

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How To Make Money On Stagnate Stocks

After bottoming out in October, the equities market bounced back with an impressive march higher. But faster than you can say “Happy birthday, bull market,” government shutdowns and other items loom in the horizon.

So, if you’re like most U.S. investors, you’ve probably got quite a few stocks in your portfolio that are now trading below freshly tagged multi-year highs. Since previous price peaks can act as areas of technical resistance, it’s only natural to be concerned about a forthcoming period of consolidation. Or, to be brutally honest — stagnation.

Fortunately, there’s a simple option strategy any investor can use to generate immediate income on his equity investments — even during those frustrating times when the market is grinding sideways.

A covered call is an option that you sell (or write) on a stock that you’re holding in your portfolio. By selling to open one call option, you’re accepting the obligation to deliver 100 shares of the underlying equity at the strike price of the option, should the stock price surpass the strike price, prior to the contract’s expiration date (in other words, should the option go “in the money”).

To build your cash-collecting call trade, take a look at a price chart of the security in question. You’ll need to pinpoint where you expect the shares to find resistance, because the strike price of your sold call(s) should generally correlate with this price zone.

In the best-case scenario, you want your sold call to expire worthless — or “out of the money” — so that you can (a) retain the entire premium received as pure profit; and (b) avoid taking any further action to close out the trade, which would rack up additional brokerage costs.

On the other hand, a call that’s too far away from the stock’s current price will barely be worth the effort. To see what we mean, simply check out the option chain of any given stock. As your eye travels over higher and higher strike prices, you’ll see the premiums begin to vanish.

Luckily, in the age of 1-point and 2.50-point strike prices for many popular stocks, it’s much easier than ever before to find a happy medium for your focus strike.

Once you’ve selected your ideal strike price, you’ll want to narrow your focus to shorter-term options. The comparatively richer option premiums of longer-dated contracts may be tempting, but trust us — the covered call strategy is best conducted over a relatively narrow window of time.

Put simply: The shorter the time frame of your trade, the less opportunity the shares have to rally above your focus strike. Plus, the effects of time decay are more pronounced on options that are closer to expiration — and in an option-writing strategy, time decay is your best friend. As the contracts shed their time value at an accelerating pace, they’ll naturally decline in price. This means the calls will be cheaper to buy back in the event that you should decide to liquidate your position ahead of expiration.

Investors should also be aware of the stock’s historical volatility, particularly as it relates to the option’s implied volatility. Equities with relatively low historical volatility (that is, slow-moving stocks) are attractive covered call candidates, because it suggests a relatively low probability of drastic price swings that could put you at risk of assignment. When implied volatility is inflated relative to historical volatility, it points to prime premium-selling opportunities.

On that same note, though, don’t forget to check the corporate calendar. A looming event, such as an earnings report or product launch, could be the underlying cause of inflated volatility. These events can often translate to significant price changes in the underlying stock, which raises the risk profile of a sold call position.

So, having selected an appropriate strike price and expiration month, your next responsibility is to place the trade with your broker. In order to make sure this is a covered call, be sure you sell no more than one option contract for every 100 shares of stock you own. Pocket your premium, and then sit back and wait for the options to expire worthless, as you predicted.

However, following a two-year rise in the broader equities market, it’s quite possible that you’re holding a few stocks in your portfolio that have delivered healthy returns. If you’re satisfied with the gains you’ve collected and are ready to move your investing capital elsewhere, writing covered calls is a savvy way to “get paid to get out.”

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The Right Philosophy for Covered Call Trading

When getting started in covered call trading you have so many options available that it can be overwhelming to determine where to begin.  Before you place any trades, you have have an ideal of what your perspective should be.  This is where you want to keep it simple so you don’t get stuck in option overload.  Here are some suggestions:

  • Keep it simple.  Don’t sell uncovered options because they represent free money because the stock can’t move that far.  This can cause some humongous loses beyond your magnitude of capital.
  • Always keep it safe.  You should know your risk tolerance and don’t venture beyond it.  If it feels risky, then it is too risky for your mental risk avoidance.
  • Keep it sensible.  Don’t trade anything that takes you beyond your sleeping and eating points.  Stay within your comfort zone.
  • Keep it diversified.  You gain some level of safety through buying different stocks in different industries than a large trade of a single stock.
  • Keep it disciplined.  Always stick to your trading plan in all cases.  More often, losses occur and get larger because of a lack of discipline.
  • When you implement a trade, you should have these tow items in your head:
    1. Set an approximate goal – the point where you expect the strategy to produce profits.
    2. Set an exit point to be used if the trade goes against you.

You should keep in mind that selling calls against your stock holdings is safer than just holding stock.  Here, the concept is to continue owning stock but to give yourself some downside protection and to get some income from the option premium.  This approach is not as exciting as buying calls and anticipating a hugh stock rally.  However, our goal is to preserve our capital so we can continue to create a monthly income.

Know Your Potential Risk in Covered Call Trades

The greatest source of risk in a covered call trade is the stock you own in the trade.  Losses are almost always the result of a price decline in the stock or the overall market.  Here is a list of primary risks in covered call trades.

  1. Decline in the stock’s price forces the trader to make adjustments.  This can happens to anyone but rarely happens with disciplined stock selection.  This is why you want to stay with safe stocks with great fundamentals.
  2. Traders fall into the assignment trap when a stock pulls back and they write calls at a strike price below their cost basis.  Then, when the stock recovers the trader will be assigned at a loss or buy back the calls.
  3. The trader will roll up to a higher strike price when a price spikes only to see the price backup to previous levels.  This will increase the cost basis as you paid more to buy back the short call than you received in premium.  You must first determine that the stock price will hold the new higher price before making this move to roll up.
  4. When the trade changes, traders want to add on options to grab more profits or to hedge their position.  These types of strategies should only be done by the experienced trader with knowledge of how add ons change the trade dynamics of risk.

All of these risks can be linked to the trade discipline or lack of discipline in the heat of the moment.  How many times have you seen a stock price spike one day and then pull back over the next few days?  this happens all the time so the trader must be disciplined not to immediately over react without confirmation of the move.  For experienced traders, they know how to determine if the price move is for real and when to make the right trade adjustment.

How to Get More Protection from Stock Price Declines

In a flat to bullish market, most call writers will sell an at-the-money call on the stock they own.  the rationale for selling an ATM call is that they have the highest premium in terms of time value.  Of course, the option seller can sell at any strike price.  What should the call seller do in a market driven by fear such as potential debt defaults, FED changes, financial chaos, etc.?  The smart call writer will change their strike price to get more downside protection.

Suppose you want to write a call on a stock that you are concerned about a potential price drop,  you can look to write an in-the-money call.  The stock is trading at $7.80 per share.  You can write the $7.50 call for $0.90.  This call has a $0.30 intrinsic value so you are getting $0.60 in time value. As long as the stock is above $7.50 at expiration you keep the $0.60 in time value and the $0.30 intrinsic value.  Now you have created a situation where you still make money if the stock declines by 3.85%.

Let’s try another example.  The stock is trading at $136.00 per share.  You can sell the 135 call for $10.25; the 130 for $13.15; the 125 for $16.40; the 120 for 20.05.  You can go down to the 120 call strike to produce a 13% downside protection.   Yet you still get a $4.05 time value premium that is almost a 3% return.  Now you have created a situation where you still make money if the stock declines 13%.

Considering an average volatility, this is a great way to protect yourself for an anticipated price downturn.   While selling ITM calls does not usually realize a return as high as selling ATM calls, it does have the benefit of creating more downside protection for the stock price to fall and still return a profit.  You should only sell ITM calls if you are willing to let the stock be called away.

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Why Sell Covered Calls?

Sellers of covered calls seek two objectives: additional income from their stock portfolio and protection from a market decline in the price of their stocks.  The call premium helps the option writer to achieve these goals.  With the covered call strategy, you can use stocks you already own or you can purchase new shares to sell covered calls on.  In either case, you will not be overly concerned about the the price movement of your stocks over a period of time.  However, you will only write covered calls on stocks you already own.
 
We can apply this call writing strategy to dividend paying stocks.  You will be getting two sources of income: the dividends and the premium you received from selling the calls.  In addition, there is potential for a third source of income if the stock were to increase in price.  If we were to allow the stock to be called away, we would receive the strike price in addition to the premium and dividends.  This is an outstanding scenario where you can potentially receive three sources of income from one investment!

However, the call writer does not have to remain obligated to deliver the stock.  The writer can terminate the obligation if it has not been exercised by purchasing to close an identical option at current premium price.  Also, if the option is exercised, you do not have to deliver the original stock as you can purchase new shares to fulfill your delivery obligation.

When you write a covered call, you still own the stock and can receive all dividends paid before the options expire.  When you sell options, you begin with an immediate profit rather than an uncertain potential gain.  The most you can make is the premium received and the price of the strike minus your cost of the purchase of stock.

There are always opportunities for investors to use options are part of their total investing plan.  With careful stock selection and monitoring of your position, selling options can:

    • Boost annual income by 15 percent or more;
    • Be used for tax benefits and low costs;
    • Offer a variety of choices such as the underlying stock, strike prices and time periods.

The best rule: never buy options, only sell them!  Buying options is speculation while selling options is investing.

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