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April 1, 2004
A Fast-Start program for
budding covered call writers
By John Brasher, CallWriter Publisher
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Talk about a question
we get a lot, this one may be numero uno:
"I'm a novice/inexperienced
covered call writer and not sure how to proceed. Do you have
any advice which of your Real Time Lists™ are the best
or safest for me? And do you have any tips to increase my
chances of trading successfully?"
Well, yes we do! Covered call
success is not that hard. And below we're going to tell you
the number one covered call writing tip!
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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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