Covered Call Strategy: Do’s and Don’t

Covered call option trading strategy is probably the oldest and most popular trading strategy involving stock and an option. Usually, it is one of the first option trading strategies that a beginner option trader learns when transitioning from stocks to options. The attraction of simplicity lures investors and traders alike thinking they have found a holy grail of successful investing and they can now beat the market.

Before proceeding further, Let me first explain what a covered call-is

1. Buy Stock
2. Sell Call to collect income
3. Wait to let it expire or adjust

As simple as that!

Here is how a risk reward chart looks like.

There is no easy money! Let’s be clear about that. Successful investing requires hard and smart work.

So before you jump into covered call writing, here are a few things you need to understand well:

1. Buy stock (easy part); which stock (hard part)?
2. Sell Call: There are hundreds of call options, which call option should you sell? And why?
3. Wait & watch: The stock goes above the strike you sold, or continue to drop wiping out the protection you thought you had by selling the call. And during the process you are scared by the losses that you decide to sell stock and buy back call…to see it all come back….

Recently an OP reader asked me this question-

But when I try to write covered calls, not those stocks but others, I am not doing so well. I guess I write covered calls when a long position has moved against me. I look at the chart, I say no problem, that’s going down, it’s $7.47. I’ll write the $8 call 6-8 weeks out … and while the stock drops to $6.88 short term, it’s happened more than once that in the last week of the option the stock zooms over 8 – temporarily –
but just enough to force me to either give up the stock or buy the option back.

So is my problem reading charts 2 months in advance, or writing calls when
panicked over being underwater in a stock?

The real question: how do you decide where, when, how long to write a covered call?

This is a very common issue.

The primary objective behind the covered call strategy is to generate additional income or provide defined protection. And in order to achieve one goal, you will have to trade-off another. But whether you are generating an income or defining protection, you are doing so for an underlying asset (e.g. stock) which is your long term holding.

Let me give you a simpler analogy-

You purchased a house that you think will appreciate over a period of time. Now you are renting this house to generate additional income along the way. However, if you bought the house at wrong time, you might still suffer a capital loss and yield may not justify the principle loss. But if you purchased the house with a very long term view and at right valuation (i.e. think margin of safety), the net yield might still provide cushion during bad times.

Stocks are priced more frequently than houses. Everyday pricing weakens our emotions. It’s easy to find daily, hourly charts for stocks but not for house. Thus, we take short term view on stock while longer term on house.

So the question you may want to evaluate is this-

Is my stock investment a long term holding? And Did I pay the correct price?

If the answer to two is Yes, over the “long run” stock value will materialize while generating additional income from covered call.

Don’t simply trade covered call strategy just because it is cool to do so, or just because IVs are high and calls are providing you good premium. Do it so after evaluating whether or not you would want particular underlying to be your long term holding and are you paying the right price for your long term holding?

In the next part, I shall explain some criteria that you may want to keep handy while evaluating covered call strategy. This will include which strike? What kind of stock? Etc.  Part-3 will explain about protection and some adjustment strategies. You may want to stay connected via twitter, facebook or simply join our mailing list (right side bar).

If you are trading covered call and you have questions that you would like to be addressed, please mail those to me -> Ask@OptionPundit.com and I shall be glad to answer those.

Profitable Trading, OP