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.
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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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