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The Biggest Mistake New Call Writers Make

Covered call trading is not like directional trading which has an objective to time the movement of a stock in the direction it is moving.  Covered writing is a game of regular, incremental returns.  The covered call writer’s objective is to collect the option premium for income without taking any damage to the downside of owning the stock.  The secret to success for the call writer is to make smaller, more consistent returns compared to a advanced option trader who makes many bets waiting for a 50% – 100% winner.  The biggest mistake by new call writers is writing a stock solely to capture the fattest time value premiums.

To improve the chances of being successful, the call writer should focus on stock selection.  The covered call trader should focus on 3% monthly returns.  However, a 15% drawdown on a trade will require 5 months of 3% returns to recoup the loss and get back to even.  This is why the Monthly Income Plan focuses on 5 star stocks signaling high quality stocks.

Why avoid the fattest premiums for a measly 3% monthly return?  The short answer is that high premiums often signal high risk, and writing calls on these options without regard to stock quality will eventually decimate your trading account.  There are two reasons that value premium becomes high enough to offer big returns:

1)   The stock is volatile and implied volatility is in line with the stock, or

2)   Implied volatility (IV) is significantly higher than actual volatility.

Simply, the higher the rate of return, the higher either actual or implied volatility (or both) must be on the options.  If two stocks had volatility of 60% we would expect the option premiums to be roughly comparable.  What if one stock had an IV of 25%?  This indicates a market expectation of less volatility in the future but it also means the investor is not getting paid for the 60% volatility risk he is taking on.  If the other stock had IV of 80% then the investor must determine what is causing the IV to be higher than the 60% actual volatility.  This usually indicates that the market is expecting some new event on the stocks such as news, announcement, earning or more.

If the IV is in line with the stock volatility, then the options are priced fairly so the decision comes down to – do you want to invest in the stock.  The rule is to AVOID stocks with spiking IV and look for a different trade.  To be conservative, look to write calls on stocks with a volatility of 40% or less.  If you are experienced and seek more income, look for stocks with volatility between 40% and 60%.  Anything above 60% I would consider high risk so proceed with caution.  You should at least look at the volatility of the stock before you invest to know what the risk of the trade may be over the coming option period.

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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
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