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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.

Playmakers Guide to Income Trading

Before you trade any options, you should have a plan.  Some players just say, I think I will try a credit spread and see what happens.  This is not the way to succeed at trading.  You must have a trading plan that treats trading as a business.
The first aspect to creating a trading plan is to determine asset allocation.  You have two choices: income generation and speculative trades.  In general, at least 80% of your trading capital should be in income generation with 20% or less in speculative investments. Why? Because when you are buying options, you are buying a decaying asset because you have limited time.  In contrast, when you sell an option, time decay is on your side.  Income strategies require selling options while speculating involves buying options.  Most of the income strategies will generate a 100% annual yield because option pricing is lower than stock purchases.  The key to getting 100% annual yields is proper risk management of each income position.
Option contracts have more time decay in the last 30 days so you want to sell options within 30-50 days of expiration.  Most of the option advisory programs sell the option speculation as you buy the option for $1 then sell it for $25.  This gets buyers stoked as they believe in the amazing kill in the options arena.  However, the majority of option business make their money on the income side.  This is why I suggest that 80% of your option trades be income generators. The best income generation strategy is to have several trades on using various income strategies such as condors, double diagonals, calender spreads, etc.  This gives you more diversification to changes in volotility within the market.
How do you define each category?  These strategies will be income generators:
  • Condors
  • Calender Spreads
  • Double Calender Spreads
  • Double Diagonals
  • ATM Butterflies
  • Covered Calls
  • Selling Puts
The strategies used for speculating include:
  • Long Calls/Puts
  • Diagonal Spreads
  • OTM Butterflies
  • Vertical Spreads
  • Directional Calenders
  • Long Straddles
Rules for Condors – selling a credit put spread out-of-the-money and selling a credit call spread out-of-the-money.
To find condor candidates, price > $75 with IV < 30% for a conservative trade and price > $45 and IV > 30% for aggressive trade.  Look at SPX, OEX, NDX, SOX and S&P 500 Futures as candidates for condors.  You want to put the trade on for 30 to 55 days.  Sell the call and put strike prices at one standard deviation or more away from current price.
  1. You want to place your spread strike prices at least one standard deviation from current price as this gives you the odds of 68% for being right.
  2. Every trade should start by determining the standard deviations of the asset – most trading software will graph the profit and probability of a proposed trade.
  3. The one standard deviation rule is the best way to manage your risk for each condor trade.
  4. The risk to reward for a condor is always terrible as you cab always potentially lose more than you stand to make on a trade.  You make money by managing your risk so you put together a long string of winning trades while minimizing any losses.
  5. Make adjustments if price moves within 10 points of strike price if more than 20 days to expiration; within 5 points of strike price if less than 20 days to expiration.
  6. If more than 20 days and price within 10 points of strike – adjustment will be to close both the call and put positions of your current condor – then open a new condor that is one standard deviation from the new asset price but is 50% larger than closed position (I.e. closed 10 contracts – then open 15 contracts on the adjustment) to compensate for the lost on your closed condor.
  7. The one exception to making an adjustment is when you have a large price gap – just close your open position and do not make an adjustment.
  8. Exit the trade when either side drops to $0.20 by closing position or rolling out to next month.
Rules for Calender Spreads – sell an ATM in front month and buy an ATM in back month.
You are looking at stocks that are trading sideways with not much price increase in recent months.  The goal is to select a stock that will stay in the existing trading range.  For example, you want boring stocks with low volitility – not free movers such as biotechnology stocks.  You make money by time decay on sold option and when volitility increases.
  1. Intrinsic volatility should be below 30
  2. No major announcements (earnings, FDA, merger, etc.) in the month you are selling
  3. Get the intrinsic volatility range (low & high IV) of the stock for the last 2 years
  4. The long option should be near the low of the IV range
  5. You want a negative skew less than 2 (short IV > long IV)
  6. The short option should bring a minimum of $0.50 
  7. Check your business plan before placing the trade
If breakeven points are hit…
  • Sell if less than 10 days to expiration
  • Redistribute the time premium (roll)
  • Add another calender position
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