It's no secret that we at CallWriter are strong proponents of covered call writing. We know it is possible to make returns from covered call writing that average 3% to 5% a month, without even using margin. That's 36% to 60% a year without even using margin. We have CallWriter members actually accomplishing these kinds of returns on a regular basis, some with comparatively little trading experience when they begin.

But what you want to know is - HOW do they do it? That's a good question, and we're going to answer it right here, right now.

Rule No. 1 - like Mom always said, do your homework.

Remember that the covered call candidates on our Real Time Lists™ of the highest returning calls are just that - trade candidates. The lists are automatically generated by our proprietary Profit Engine™ software and are presented solely by returns offered. The trade candidates on our lists have not been evaluated as trades in any way! You should do the full complement of research on any one before writing it. Never, ever write a covered call just because of the return it offers, because that is just rolling the dice with your money. You will only get away with blind writing in a good bull market (and sometimes not even then).

We show CallWriter members how to do this analysis before entering a trade. The analysis called for is not cumbersome, difficult or time-consuming but should be done every time - no exceptions. So here are some homework points to consider:

1. Be very careful with "FDA" stocks. Pharmaceutical and bio companies regulated by the FDA frequently are on the list awaiting an FDA approval or test results on a drug or device being developed. Unless you can negative this, it may be best to avoid them. The exception is for larger companies that have many products on the market, and which will not be gutted by an adverse announcement about a particular drug or device. On the other hand, the FDA stocks can provide marvelous returns. FDA stocks should always be written deeply in the money - no exceptions.

2. Pay attention to liquidity issues. It is generally a good idea to avoid stocks with less than 1,000,000 average daily volume, since they are too easily manipulated. We usually avoid call options with less than 1,000 open interest, since they are not very liquid. Absolutely avoid calls that have a spread between the bid and asked price of more than $0.20.

TIP: Big spreads on the bid/asked prices really pick your pocket. When you try to buy these calls back (close to expiration or if the stock drops), the spread will kill you - for example, the call may be bid at 0.15 but it could cost you 0.45 or more to buy it back!

3. Check for News. Stocks generally are on our lists for a reason, and you should look back at news headlines for a month or so to try to determine what event could be driving volatility. It is not always possible to find this, so don’t be too concerned. Be very wary of a stock that has moved up recently on no news that you can determine. This could mean that you haven’t found the news moving the stock, but can also mean that the stock is being manipulated, or that the market knows something you don’t.

4. Look for an earnings report. We generally like to avoid stocks that will report earnings before call expiration, because they can tank if the company doesn’t hit its earnings number – and can tank like Caterpillar did earlier this year even if it hits its own earnings prediction but misses the number the market expects (the so-called “whisper” number). In fact, stocks frequently go down even when the earnings report is good, because the stock has already run up in price, and by the time news comes out most of the people who want to buy the stock have bought it. They sell when the news comes out. This is called buying the rumor and selling the news.

TIP: If a stock will report earnings before option expiration and has been moving up on no particular news, this indicates a run-up based on earnings expectations. Such a stock should only be written well ITM. In order to write stocks reporting earnings, it is essential that you look back over a couple of years of history to see how the stock reacts to earnings reports. You want to know if the stock typically runs up on earnings expectations before the report is issued and if it sells off on the actual earnings announcement. If the stock tends to sell off, either write it deep in the money (premium should be at least 15% of the stock's current price) or pass on the trade.

CallWriter teaches other analysis steps, such as evaluating the stock's charts (technical analysis), but the foregoing list provides an excellent start.

Rule No. 2 - stick to the safer roads.

If you are primarily interested (as are we) in safety as opposed to sheer return, then there are two lists to start with: the Deep in the Money and S&P 100 lists.

Please note that the covered call plays discussed below should NOT be considered
picks or recommendations of any kind, they are for example purposes ONLY.

Deep in the Money List:
Plays on this list are at least 10% in the money (ITM), so if the stock is $20, the list could not show you any call with a strike price above $18 ($2.00 - or 10% - below the stock price). In our experience, our Deep in the Money lists contain stocks that tend to have low volatility, meaning less likely to tank on you. Deeply ITM calls as a general rule provide the lowest return of all calls, but on the other hand always provide the most protection.

Deep ITM Examples:

In March, we wrote a March 25 covered call on Sepracor when the stock was $28.34 but got a $4.90 premium, which protected us down to 23.44. Return: 5.5% for a few weeks. Downside Protection: 17%.

Recently, NPS Pharmaceuticals was 23.75 on our list and the April 22.50 call was paying a $2.80 premium, which protected down to 20.95. Return: 6.53% for a few weeks. Downside Protection: 11.7%.

Recently, Genta was 10.46 on our list and the May 7.50 call was paying a $3.80 premium, which protected down to 6.66. Return: 8.03% for a 51-day trade. Downside Protection: 36.3%.

ITM calls hedge your risk through the huge premium. However, traders should not get lazy and fail to do the analysis, because a stock that has a huge drop can hurt you even with the large premium.

Still, iIf you are concerned about the stock dropping while you're in the trade or uncertain of your ability to do basic chart analysis, the Deep in the Money List is probably your best bet.

S&P 100 List:
These stocks tend as a rule to be far less volatile than others and to move less. The returns generally are not so good as on Nasdaq 100 stocks or sub-Nasdaq 100 stocks, but the stocks are far less likely to hurt you. On the other hand, they tend to be much more expensive stocks. As always, do your research, since any stock can go down.

S&P 100 Examples:

Recently, Nextel on this list at $24.65 and the May 25 call was paying a $1.20 premium, which protected down to 23.45. Return: 4.87% for a 51-day trade. Downside Protection: 4.87%.

Recently, Boise Cascade was 34.74 on our list and the May 35 call was paying a $1.60 premium, which protected down to 33.14. Return: 4.61% for a 51-day trade. Downside Protection: 4.61%.

Recently, Halliburton was 30.45 on our list and the May 30 call was paying a $1.70 premium, which protected down to 28.75. Return: 4.11% for a 51-day trade. Downside Protection: 4.11%.

Rule No. 3 - safely maximize your returns.

Everyone is interested in making the most money safely and we at CallWriter certainly believe in maximizing your returns. However, be aware that writing LEAPS™ or other calls with multiple months left until expiration will never provide the best returns and keep you in the trade too long.

Write at the money (ATM) or in the money (ITM). Things being equal, the highest returning calls are the at-the-money (ATM) calls. They offer decent downside protection, though not nearly as great as the ITM calls. ITm calls offer lower returns but vastly greater downside protection. Again, if you are concerned about a pullback, or unsure of your ability to size up the stock's technicals, write deep ITM until you get your trading sea legs.

TIP: Deeply out-of-the-money (OTM) calls - more than 3% or 4% OT -) should only be written on rising stocks in a rising market.

Write the Front Month. The best returns are almost always obtained by writing calls in the front month (the month that will expire next), unless the front month is expiring in 10 days or less. The reason is that the fattest premium is gotten for the front month. Put differently, if you sell a call 3 months out, you won’t get anything like 3x the premium for the front month, but you will be in the trade 3x longer. We really don't like being in a covered call trade more than six weeks: it's an income strategy, not a buy-and-hold strategy. Remember that the further out in time you write, the longer you are at risk in the trade.

How can covered call writing work so well? Simple, you aren't investing for the long term and don't have to be right about the stock's direction more than a few weeks. Suppose that analysts are saying stock XYZ will fall a lot this year, maybe 30% to 50%. This means stock investors should run from it, of course. But the covered call writer is ONLY AT RISK for the time he/she is in the trade. And you don't care what the stock does over the long term or intermediate term:

TIP: You are only concerned about the likelihood of a drop, and the extent of a likely drop, over the trade's duration! If you are consistently writing ITM with premiums that are 15% or more of the stock's price and being careful about the stocks you trade, it will be very hard for the market to hurt you.

A quick note about ITM writing: Writing deeply ITM is not the cure for every ill that can beset the covered call writer. You might recall the tech crash of March 2000 when unprofitable but high-flying tech stocks dropped like rocks. Looking at such stocks, you might ask, as do covered call writing opponents, how would the covered call writer have fared differently? The answer may surprise you:

First, a covered call writer trading those stocks would have fared little better, but would at least have pocketed a fat premium up front.

Second, no one following the CallWriter Method would have touched those stocks, because they were very unprofitable (had never made money) and were trading at a sky-high P/E (price to earnings ratio). You must be aware that if you insist on writing garbage stocks, ITM writing will not save you when they tank.

The tips above aren't by any means all the things CallWriter teaches for consistently profitable covered call writing. In fact, they are only the tip of the iceberg. But you would be amazed how many of our members are making consistent profits using little more (and in some cases, even less) than the tips above!

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