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How To Recover From A Covered Call Trade

To remind you, this trade involves holding at least 100 shares of a company’s stock, then selling call options against them (one options contract for every 100 shares you own).  If the underlying stock declines, you’ll begin to see the option’s premium erode, too. But depending on the timeframe of the trade, you may see a greater loss in your stock position in real dollar terms than you will in your option position.  The objective of covered call writing is to produce monthly investment income and to protect your capital.

To calculate your exact current position in the trade versus when you placed it, you must:

  • Get the quote for the stock.
  • Get the quote for the option.
  • Subtract the current option price from the current stock price.
  • Compare that number to your net cost of the trade when you executed it.

The net cost of the trade is the breakeven when you enter a trade.  You can use this number as your threshold to take action if the stock price decreases to this point.  Some covered call investors use the breakeven to unwind a trade.  If the new net number is below your stop-loss threshold – let’s say 20% – then you have the following options:

  • Either: Stick with the position and hope that the share price recovers, so you can sell another option at expiration.
  • Or: Reverse the trade by buying back the current option and selling the stock.
  • Or: You can also buy back the option and sell another one at a lower strike price to mitigate some of the loss. However, if the new strike price you choose is below your cost, then you’re going to take a loss there, too.
  • Or: Buy a protective put on the stock used in the covered call trade.  The put will increase in value if the stock price falls so it will hedge losses from your stock ownership.  Of course you can buy a put as protection for all covered call trades especially when you plan to continueously sell calls each month on the same stock.  If you use a protective put, then select a month with a longer timeframe than the call sold against the stock.

But there’s one way to pretty much avoid this situation entirely… Sell deep-in-the-money calls against your position.  While this does reduce the overall return available, the upside is that it also reduces your net cost significantly and thus provides a nice cushion against risk.

Option Basics – What is an Option?

An “option” is a standardized contract originated by the Options Clearing Corporation (OCC) that is exchange-listed.  A stock option is a legal right, but not obligation, to buy or sell shares of a specific stock for a fixed time and a fixed price.  The fixed price gives the option holder the right to buy or sell at a fixed price known as a strike price or exercise price.  The fixed time indicates that a option has a limited life for only a specific period of time then expires.
 
There are two types of options:
 

  • Calls – the right, but not the obligation to buy the underlying stock
  • Puts – the right but not the obligation to sell the underlying stock

How to buy & sell Options

Click to enlarge.

The underlying stock are the shares of stock that are subject to a stock option.  The underlying stock can also be an exchange-traded fund, stock index and other tradeable securities that have options.

Each listed call or put option covers 100 shares of the underlying stock.  Stock options expire on the Saturday following the 3rd Friday of each month.  This 3rd Friday is the last day the options can be traded as the market is closed on Saturday.  If the 3rd Friday is a holiday, then the last trading day will be the Thursday before.  Recently, weekly options have been open on a limited number of stocks and ETFs.  These weekly options are opened on each Thursday and expire on Friday of the following week.  This gives the weekly option a time period of 8 days from opening to close.

There are many different calls and puts trading on each security that is optionable.  Each call and put strike price of each expiration month is a separate option series.  To be part of the same series, the options must be of the same type and have the same expiration, strike price and underlying security.  

For investors, option equal income.  I have always like to identify multiple streams of income from my portfolio. For many, they like to diversify using different stocks in different industries. Others like to add additional investments such as bonds and real estate to create diversification. There is nothing wrong with investors looking to create different types of income. In fact, I believe it may be as close to the holy grail as any concept in investing. I use multiple products and strategies to create multiple streams of income. 

I am focused on generating consistent monthly income by selling options for premium using low risk strategies. You can see more investments at my website: getrichinvestments.com

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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

Investing Wisdom from Warren Buffett

In his essay for “Getting There,” Buffett elaborates on a message that he thinks “is very important to get across to younger people”: Take care of your mind and body.

Sounds simple, right?

But Buffett takes it a step further by offering an analogy: “Let’s say that I offer to buy you the car of your dreams. You can pick out any car that you want, and then when you get out of class this afternoon, that car will be waiting for you at home.”

As with most things in life, Buffett says there’s just one catch: It’s the only car you’re ever going to get…in your entire life.

“Now, knowing that, how are you going to treat that car?” he asks.

“You’re probably going to read the owner’s manual four times before you drive it; you’re going to keep it in the garage, protect it at all times, change the oil twice as often as necessary,” says Buffett. “If there’s the least little bit of rust, you’re going to get that fixed immediately so it doesn’t spread — because you know it has to last you as long as you live.”

And then, like a bag of bricks, Buffett hits us with a brilliant realization: The position you’re in with your car is exactly the position you’re in concerning your mind and body.

In other words, the way you treat your car should be no different than the way you treat your body.

“You have only one mind and one body for the rest of your life,” Buffett says. “If you aren’t taking care of them when you’re young, it’s like leaving that car out in hailstorms and letting rust eat away at it. If you don’t take care of your mind and body now, by the time you’re 40 or 50, you’ll be like a car that can’t go anywhere.”

Now, you might be wondering whether Buffett practices what he preaches — considering how vocal the billionaire has been about his love for Coca-Cola, hamburgers, steaks and hash browns.

For the most part, the answer is yes.

When a New Jersey nutritional dentist wrote Buffett a letter encouraging him to eat more healthy foods, he responded by saying his diet isn’t as bad as most might think.

“I have a wonderful doctor who nudges me in your direction every time I see him. All in all, I’ve enjoyed remarkably good health — largely because of genes, of course — but also, I think, because I enjoy life so much every day,” he said in his response.

And back in 2007, when he was in his late 70s, he told CNBC that his doctor told him two years before: “Either you eat better or you exercise.”

Buffett chose the latter, which he called “the lesser of two evils.”

How to Retire Rich – Master the Money Game

Retiring rich may be more possible than you think.

Especially if you’re young, you don’t even need to make a lot of money to end up wealthy, says Tony Robbins, a self-made millionaire and the best-selling author of “Money: Master the Game.” If you consistently set aside a portion of your earnings, whether you make $40,000 or $100,000, and let it grow over time, you could end up with a seven-figure portfolio.

If you’re just starting out in the workforce, “you have the greatest gift on earth: time and compounding,” he says. All millennials need to do is to use those advantages, he says, adding: “When they asked Warren Buffett, ‘What made you a wealthy man? He said, ‘Good genetics, time and compounding.'”

How exactly can these ingredients — time and compounding — help you build your net worth? For starters, it’s important to understand how compounding works.

What is compound interest?

Compound interest makes a sum of money grow at a faster rate than simple interest, because in addition to earning returns on the money you invest, you also earn returns on those returns at the end of every compounding period, which could be daily, monthly, quarterly or annually.

That’s why compound interest causes your wealth grow faster. It’s also why you don’t have to put away as much money to reach your goals.e dialog

Compound interest can also work against you when it comes to loans: It means that every year or month, whatever the frequency specific to your loan, the amount you have to repay gets bigger. So the longer it takes to pay off your loan, the more you’ll owe in interest.

Why does time matter?

The sooner you start to invest your money, the more you’ll benefit from compound interest. Starting to save early means you don’t have to put away as much over time — and even a few years can make a big difference.

To show just how advantageous it is to start saving and investing early on, personal finance site NerdWallet created a chart showing the percentage of each twice-a-month paycheck you’d need to set aside to have $2 million saved by the time you’re 67.

It assumes two different starting points, age 22 and age 30, and that you’re start with zero dollars invested. It also assumes a 6% average annual investment return and various annual salaries.

The 22-year-old has just an eight-year head start on the 30-year-old, but that makes a significant difference in how much is needed to save per paycheck. Scroll over the bars to see the exact numbers.

How to use compound interest to your advantage

Almost anyone save and invest of portion of their paycheck, says Robbins, no matter the size of their salary: “Oftentimes people tell me, ‘I don’t have any money. … I don’t know where to start. I’ve got to wait until I have money before I begin [investing].’ That is the biggest mistake you can make.”

Even if you can only save 1% to 5% of your income in a retirement account, start there. “What you want is consistency,” Robbins says. Then, work towards setting aside 10% to 20%. That may sound daunting, but it’ll be easier to do if you make it automatic, meaning that you have your contributions automatically taken out of your paycheck and sent straight to your retirement account.

As for where you should invest, the simplest starting point is to contribute to your employer’s 401(k) plan, a tax-advantaged retirement savings account that many companies offer, or other retirement savings accounts, such as a Roth IRA or traditional IRA.

“What you want is consistency.” -Tony Robbins, best-selling author of ‘Money: Master the Game’

Many experts, including Warren Buffett, recommend investing in low-cost index funds, like ones that track the S&P 500, which holds stocks for 500 of the largest companies in the U.S., including Apple, Exxon and Johnson & Johnson.

You can also look into robo-advisors, such as Betterment, Wealthsimple and Wealthfront. These are automated investing services that use an algorithm to determine the kind of portfolio that’s right for your age, risk tolerance and time horizon.

No matter how you choose to invest, the most important step is to open at least one account and start contributing to it consistently to take full advantage of compound interest. The earlier you start, the better off you’ll be.

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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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Trading a Calendar Spread with LEAPS

Previously, we posted information on doing a covered call using a LEAPS option. Call calendar spreads are similar to a covered call. One part of the call calendar spread is buying a LEAPS call instead of owning the stock. Then, we can sell call options (like a covered call) with less time to expiration (the calendar part). For example, we can buy a call LEAPS with two years of time and sell a call option in the next month. It the strike price of the LEAPS is the same as the call sold, then you have created a call calendar spread. It the strike prices are different, then we have created a diagonalized calendar spread.

My preference is to buy a LEAPS that is in-the-money. This gives you a higher delta so you captured more of the stock price move. A good target is to buy a LEAPS call with a delta of 0.70 or higher. If the stock makes a strong up move, then you gain more profits in the LEAPS call. Also, ITM LEAPS give us more choices in what strike prices to sell the call. In comparison to a covered call with stock, we DO NOT want to e exercised in the LEAPS position. The reason is simply that we do not want to lose the time value of the LEAP call. You can buy an ATM or OTM LEAPS call, but your delta will be lower and it is more difficult to sell a call until the stock price moves up.

When I sell a call, I like to sell the shortest amount of time available because it will decay faster (more profit per day due to time decay) than a call with several months of time. I like to use the existing month and the next month for call sells. I like to sell an OTM call when holding a LEAPS because the call sold is all time value.

The bottomline: Your returns will be leveraged. For example, you may get a 3% return on a covered call but that same return will be 12% if your underlying is a LEAPS instead of stock. Since we are using LEAPS, if the short call strike price is above the stock then it will expire worthless. You can then sell a call against the LEAPS for the next month. If the stock price is greater than the short call, you can back back the short call or roll it up to a higher strike price.

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How to take Advantage of High Implied Volatility

Implied Volatility (IV) gets high when a company has some impending event that can move the stock price.  The impending event sometimes refers to the stock as being a special situation stock.  The impending event causes the option IV to change based on the likely stock price move.  Here are some causes that increase IV:
 

  • There is a pending event such as an earnings report, FDA ruling, etc.
  • A significant news event is pending on another company in the same industry
  • The company’s industry is more volatile due to expected changes
  • The stock has a higher level of volatility so its options are more expensive
  • An aberration occurs as there is no apparent reason for more expensive options.

When a stock is already moving its price, option premium will be high.  IV will simply reflect that volatility and potentially more volatility. Options are also more expensive when a stock is in a confirmed trend.  
 
Time value that is inflated due to spiking IV will collapse when the event causing the spike arrives.  You do not want to be long an option when IV collapse as you can lose money even if the stock price doesn’t fall.  In general, you want to buy low volatility and sell high volatility.

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To use high volatility to your advantage when you are Bullish:

  1. Buy stock as options are expensive;
  2. Write covered calls to collect higher premium;
  3. Sell naked or cash-covered puts for higher premiums;
  4. Write bull put spreads for higher credits.

If you are bearish with high volatility:

  1. Short the stock since puts are expensive;
  2. Sell naked calls;
  3. Write bear call spreads for credit.

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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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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