As mentioned, successful covered call writing is dependent on good stock selection and strategy approach. The method described here bridges this gap:
- Stocks must be $20 or less and have higher-than-average call option premiums.
- Sell slightly out-of-the-money (OTM) call options with less than 30 days until expiration.
- The 50-day simple moving average (SMA) must be pointing upward or traveling in an upward trend .
- The 20-day SMA must be trading above the 50-day SMA.
- Price action must be trading above the 50-day SMA.
- The oscillator indicator Williams %R must dip below the –80 mark to set up a possible signal.
- Entry is triggered when Williams %R rises up through the –80 level.
- Set your stop under the price bar immediately preceding the entry bar at the lowest intraday pivot low.
- 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.
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.