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Covered Call Strategies

So we now understand the risk profile of a covered call, andcovered call writer Anna how the two elements fit together, I would now like to introduce you to the two simple strategies that I suggest you start with in developing your covered call strategies, which I hope will give you an introduction to this under used trading strategy.

Covered Call Writing Strategy

So given all the strike prices and options available, how do we choose a sensible strategy in order to write our first covered call. As you will appreciate there are many, many, covered call strategies that can be adopted, but the two I will teach you here, will give you an introduction to the process, and if you feel it is a technique you enjoy, then by all means develop this to other strategies. The mechanics will always be the same. The reason I discuss this approach is because it is the one I have used myself and found to be very effective, as it allows us to use the erosion of time to our advantage, and maximises the opportunities for writing repeat options on the same stock, which is always nice!! 

The buy write covered call strategy is very simple - we select and buy our stock, place our stop loss,  and then sell our call option - job done! Our objective in using this strategy is as follows :

Clearly in order to write a call option that we want to expire worthless, then we need to look for stocks which are trending sideways. In other words neutral to slightly bullish. We are looking for a stock that is moving sideways and with an HV that is falling and certainly lower than it was 3-6 months ago - HV current is less that HV past ( for an explanation of volatility please go to the online option trading site).Naturally this needs to be a stock that has and option! It is important to realise ( as I have said before ) that in choosing our stock we are not looking at it from an investment viewpoint, but purely from a speculative point of view. We are not selecting the stock for investment, but its benefits as the underlying asset for our covered call. Now whilst this covered call writing strategy can be applied to stock markets around the world, my own personal experience is limited to the US and UK markets, of which I prefer the US markets. This is simply because there is so much more choice, with several thousand option stocks available. The UK markets are very limited with only 100 ( approx) shares to choose from - in addition as I have mentioned before the underlying asset is 1000, so you need to purchase 1000 shares for each contract. Having said that, the UK equity options are blue chip shares, many in the FTSE 100 so they are generally quality companies with relatively low HV, so they are relatively safe. In addition you will find that these stocks generally have lower HV than those in the US.

stock chart for covered call writing candlestickOK, so the first thing we need to do is to go through all the stock options available, and draw up a watch list of stocks which may be suitable. Now I am assuming that you will be using a technical approach, by analysing the candlestick charts of the particular stocks. If you need more information on this aspect of trading, please follow the link to the Making Bread web site where you will find several pages giving an introduction to technical analysis and candlestick analysis. Let's suppose we have found several stocks, which have options series quotes, and are trending sideways in a nice channel. We look at the option series available and also check the Implied Volatility and Historic Volatility charts. We find a stock which is showing a wide gap between the HV and IV with the IV above the HV. Ideally you do not want the IV to be too high as this will undermine the strategy, so I would suggest that somewhere between 20% and 40% is ideal. Anything higher is too volatile. Remember you are looking for stocks which have little chance of being exercised so 'placid' stocks are the order of the day as shown in the above example. The price movement between May and July would be ideal.

Having found what we feel is a suitable stock with an appropriate HV/IV profile, we then look at the option chain. Now you can approach this strategy in many ways, but the way I have always used it is to sell the nearest available call option, with a strike price which is just out of the money. Why? Two main reasons - firstly remember the time decay graph - as time expires, the extrinsic value of time erodes faster and faster, which makes it more and more unlikely that the stock will achieve the strike price - so time is on our side, and the less time available, the more likely the option will expire worthless for the holder. Secondly, this gives us three bites at the profit cherry as we have the premium from writing the call, a possible profit from our stock should it reach the strike price, and thirdly a dividend from holding the stock. Now whilst this is difficult to achieve, it can be done - I have achieved it several times but you will need to plan the trade carefully. So to recap, we would look for the following:

In order to help with the example I have reproduced the McDonalds option chain below ( assume it meets our IV/HV criteria which I have not checked, as this is just an example) :

McDonalds - MCD : Expiration Month : October 2007
(Nov 07) (Dec 07) (Jan 08) (Mar 08) (Jan 09) (Jan 10)
Sym. Last Chg. Bid Ask Vol. O.I. Strike Sym. Last Chg. Bid Ask Vol. O.I.  
     OCT 07  Calls 21 days to expiry MCD @ 54.56           OCT 07 Puts
MCDJI 9.90 0.00 9.50 9.80 0.00 732 45.00 MCDVI 0.05 0.00 0.00 0.05 0.00 15117
MCDJW 7.80 0.00 7.10 7.30 0.00 2853 47.50 MCDVW 0.08 0.00 0.00 0.05 0.00 6606  
MCDJJ 4.60 0.00 4.70 4.90 0.00 2241 50.00 MCDVJ 0.15 0.00 0.10 0.10 0.00 7425  
MCDJX 2.59 0.00 2.55 2.65 0.00 4842 52.50 MCDVX 0.48 0.00 0.40 0.25 0.00 3376  
MCDJK 1.00 0.00 0.95 1.05 0.00 5017 55.00 MCDVK 1.33 0.00 1.30 3.10 0.00 2769  
MCDJY 0.25 0.00 0.20 0.30 0.00 3736 57.50 MCDVY 3.50 0.00 3.00 8.20 0.00 1517  
MCDJL 0.05 0.00 0.05 0.10 0.00 2438 60.00 MCDVL 5.80   5.40   0.00 59  

Now, we are at the end of September so we would look for the next option which is October, with an expiry in 21 days. This is perfect as time is on our side, not the holders. The stock is currently at $54.56 and the next closest OTM call option strike price is $55.00, so this is the one we would select. The premium on the call looks respectable in terms of a return ( which we will look at later )

We are now ready to write our covered call ( at last!!) but before we do, there is one last thing we MUST DO and it is this - both stocks and options are extremely susceptible to movement before major announcements. Now it is vital, that you DO NOT open a trade just days before a company is about to announce their results, or if they are about to announce a dividend. Both of these can have a major impact on both volatility and share/stock price. In the US markets this can be a real issue and involves you in a lot of work in order to ensure you do not open call positions during these periods. Most US companies announce quarterly, with the usual flurry of associated upgrades and downgrades. You must wait until afterwards to open your trade if all the other criteria are as required. The same applies to dividends. If a company goes ex-dividend then this will affect the stock and options pricing. Finally stock splits also occur from time to time so you MUST DO YOUR HOMEWORK!!!!

Now there is an excellent site where most of this information is freely available and is www.earnings.com. This is a completely free site, where you will find daily details for company announcements and other useful data - please use it to the full to plan your trades properly.

Using McDonalds as the example, we would firstly buy 100 MCD stocks to cover our call, place our stop loss at the same time and opening the position, and then sell 1 October 07 Call Option with a strike price of $55 ( MCDJK). We have now constructed our covered call option and we receive 100 x 0.95 ( $95) as our premium which we keep. We have also built in an element of profit if we are exercised - the difference between the current price and the strike price. So if we are exercised we will make a profit of $95 from the premium and $44 from the increase in stock price. If we are not exercised then we keep the premium which in the event of a decline in the stock price, acts as a hedge and reduces the overall loss should prices move South. In this case our breakeven would be if the stock price moves below $53.51, at which point the trade moves into a loss position.

Now, I am going to leave it there, and look at the second covered call writing strategy. Then we will come back and look at what happens during the life of the trade, and the likely outcomes, as well as looking at the returns likely using covered call writing as a trading technique.

 

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