Profiting with covered calls

For many, even experienced traders, the markets can be a source of great uncertainty and anxiety. Day to day, markets offer a wide variety of unknowns, from how long a trade will take, to its potential risk and reward. Not knowing can be tortuous mentally for traders, and this only is made worse in times of high volatility. While accepting that uncertainty and risk are part of the game, this doesn’t provide much comfort, exacerbating the challenge of trading itself.

This can lead to further mistakes in judgment and poor decision-making. Taking losses in stride soon goes out the window. Losing trades begin to snowball as you try to win back what you lost. 

For beginning traders with limited experience and low capital, this can be an even more frustrating and defeating experience. Beginners bravely attempt to succeed but lack planning on how to deal with not knowing where profits are being generated. This is made worse if traders are not capitalized well enough to sustain themselves through the learning curve.

However, if you could know in advance how much money you were going to make and how long the trade was going to take, then you could eliminate the two biggest causes of anxiety and failure for a trader.

A winning model

Writing covered calls has grown in popularity in recent years because of its potential to provide safe and steady returns, but many traders have an incomplete understanding of how to apply this approach in real-time.

Covered call writing is simple. A call option gives the buyer the right, but not the obligation, to purchase the underlying stock at a specified price (the strike price). The seller, on the other hand, is obligated to sell the underlying stock at the strike price. Some call writers sell (or write) calls against stocks that they don’t own. Covered call writers write calls against stocks that they have in their portfolios, or add to their portfolios concurrent to the writing of the option.

One of the biggest benefits of covered call writing is that there is limited risk because the collected premium lowers the seller’s overall cost per share. The technique also allows the sellers to calculate the profit potential in advance, as well as how long the trade is going to last before they can bank any profits. If used correctly, covered call writing can give you a steady, consistent revenue stream to enhance your equity trading profits as well as provide a steady income.

There are two challenges to proper covered call writing: Appropriate stock selection and strategy approach. If you buy a stock that is on the decline, you’re now in the awkward position of holding something that is losing value. Also, you have to find a stock whose options chain offers a high enough premium to be worth your risk, and then you must decide which option to sell and when to initiate that phase of the strategy. Complicating matters, what do you do if your position is called away? Do you repurchase the stock again? Or, if you’re not called away, what do you do when the short option expires?

These are questions that you need to have answered before you embark on this, or any, strategy.

First, you need to have or plan to purchase 500 to 1,000 shares of an underlying stock. Generally, because of commissions, it won’t be worth your while to attempt this strategy with smaller holdings, although technically it would be possible. Whatever your holdings, you will need 100 shares for each option you wish to write.

You also will need a strategy to select stocks that have good price movement, to determine where to take a position in that stock’s trend, to estimate where to sell the call option within the trend and to decide which call option to sell.

If you have these factors in place, then the following benefits can emerge: 

  1. Solid investment vehicle for medium to long-term portfolios.
  2. Potential returns of 5%-20% every month.
  3. Less risk than trading outrights.
  4. Ability to lock in gains at the beginning.
  5. Knowing how much you potentially can make in advance.
  6. Knowing how much time the trade is going to take.

The method

As mentioned, successful covered call writing is dependent on good stock selection and strategy approach. The method described here bridges this gap:

  1. Stocks must be $20 or less and have higher-than-average call option premiums.
  2. Sell slightly out-of-the-money (OTM) call options with less than 30 days until expiration.
  3. The 50-day simple moving average (SMA) must be pointing upward or traveling in an upward trend .
  4. The 20-day SMA must be trading above the 50-day SMA.
  5. Price action must be trading above the 50-day SMA. 
  6. The oscillator indicator Williams %R must dip below the –80 mark to set up a possible signal. 
  7. Entry is triggered when Williams %R rises up through the –80 level. 
  8. Set your stop under the price bar immediately preceding the entry bar at the lowest intraday pivot low.
  9. Entry confirmation is signaled when the fast EMA crosses the slow EMA, as indicated by moving average convergence-divergence (MACD). 

The 20- and 50-day SMA are used as a filter to identify periods that are ripe for long positions. This is why, for a bullish setup, price must be trading above the 50-day SMA. The Williams %R is a leading indicator that is used to signal a long entry into the trend when price pulls back, resulting in the indicator dipping under the –80 level (see “Selling in an uptrend,” below).

Entry is made on short-term strength. You enter on the close of the price bar after the Williams %R signals momentum has resumed into the dominant trend. Then, we confirm the entry by the MACD. The MACD is a lagging indicator. The MACD confirmation is not essential, but acts as a secondary signal to confirm the trade (see “Short-term gains,” below).

Sell the OTM call option with less than three weeks until expiration when either the Williams %R or MACD begins to diverge or decline. This accomplishes two things. One, it shows that a top is occurring and allows you to sell the option as high as possible. Two, selling an OTM call option with less than three weeks left until expiry puts time decay on your side and quickly devalues the call option you sold, shortening your hold time on the covered call position until you can bank profits.

For this particular approach to covered call writing, you want to avoid paying additional brokerage fees that would come from having to sell your position if the option went in-the-money and your stocks were called away.

Insurance

Longevity as a trader is synonymous with controlling risk. Your ability to play defense and protect yourself from taking any loss while protecting gains is going to serve as the cornerstone to your success.

For the risk-conscious who are worried about the stock tanking or a Black Swan event, you can protect yourself by buying a put option for insurance. Once you sell the call option, you can use part of the premium you collected to buy a put option with a strike price near your initial entry.

If the unexpected happens, and the stock falls apart, the put will protect you from a severe loss. As with any strategy the goal is to be mindful of the downside.

In trading, there always will be unknowns to deal with and the anxieties that come with them, but covered call writing lets you transfer some of that risk onto someone else. As with any strategy, the goal is to be mindful of the downside. With practice, it will help you achieve predictable profitability while minimizing risk of loss.

Billy Williams is a 20-year veteran trader and publisher of www.StockOptionSystem.com, where you can read his commentary and a report on the fundamental keys for the aspiring trader.

About the Author

Billy Williams is a 20-year veteran trader and publisher of www.StockOptionSystem.com, where you can read his commentary and a report on the fundamental keys for the aspiring trader.