Our Covered Call Lists, Briefly

CallWriter is well known for our Real Time Lists™ of the highest covered call returns, which I refer to as trade setups, or just plays. The setups on each list are arranged by flat return, with the highest return at the top of the list, and there will be as many as 30 separate plays on each list. A play could be #1 on a list or as low as #30. But does a play's position on a list in any way indicates its viability as a trade? How about appearance on multiple lists?

The first thing to realize about our covered call lists, as with lists of the highest covered call returns offered by other sites, is that the plays on them all have a high level of implied volatility (IV). Expensive options imply a lot of volatility in the underlying stock, and the more expensive they are, the more volatility is implied - the more "overvalued" they are. Since trade setups are presented on our lists by return, those higher on the list can be assumed to have a higher level of IV than those positioned lower on the list.

IV arises generally from an impending event that will affect a company (or affect a larger, dominant company in the same industry). Thus, high covered call returns are driven by news. The impending news might be an FDA ruling or clinical trial result, resolution of a lawsuit, union negotiations, a pending earnings release or innumerable other possible news events. Because high covered call returns are news-driven, and because entire industries (and even sectors) sell off and go into rotation, it is not easy to gather statistical data with great precision.

But I have learned some interesting things about where plays appear on our covered call lists, and how many appearances they make on our lists. In this article, I will be considering our mainstream lists, which are:

• S&P 100
• Nasdaq 100
• All-Markets
  • Under $10
  • $10 to $20
  • $20 to $40
  • Over $40
• Deep in the Money
• Deep out of the Money

Plays on the DITM lists must be at least 10% in the money and those on the DOTM lists at least 10% out of the money. Plays on the other mainstream lists typically present at-the-money or near-the-money covered calls, though some deep strikes will appear.

A Good Sign

Whenever you see a strong company hit #1 on one of our mainstream lists, you should be making money. Notice that I said a strong company, meaning a large company that is an industry leader (and thus does not follow a bigger company in the same industry), boasts sound fundamentals and is not historically volatile. You still have to check for news, because even the biggest companies can sell off (think Google) or face a momentous event. But the large, strong companies are the gold standard for writing covered calls. I will have a bit more to say about strong companies below.

If the play is high on our S&P 100 or Nasdaq 100 list, it usually will do well, assuming the stock's industry or sector is not troubled, which particulary needs examination for the Nasdaq 100's tech issues. A strong company high on our other mainstream lists usually does quite well, too, but may not be as robust and industry-dominant as those on the S&P 100 and Nasdaq 100 lists.

A Better Sign

When a strong stock hits high on both the S&P 100 list and one of the All-Markets lists, this is an even better harbinger of a good covered call trade. Why? The return levels on our S&P 100 list tends to be lower than those on the Nasdaq 100 and All-Markets lists, so an S&P 100 stock that makes it to a high position on an All Markets list is showing an excellent return. A stock appearing on both the Nasdaq 100 and one of the All-Markets lists also tends to be strong.

Stronger Yet

When a strong stock on the S&P 100 (or Nasdaq 100) list and an All-Markets list also hits high on our Deep in the Money (DITM) list, even more strength is indicated. The reason is that DITM returns tend to be even lower than S&P 100 list returns. In any volatility skew, DITM calls as a general rule offer little time value and one of the lowest - if not THE lowest - returns; sometimes the DITM call is the highest, but not often.

If a strong stock is ranked high on the S&P 100 (or Nasdaq 100), an All-Markets list, the DITM list and the Deep out of the Money (DOTM) list, it practically glows at night; it's like a quasar in the sky. Its presence across all lists on which it could appear means that IV is quite high for all strikes close to the money and even deeply in and out of the money. That is, there is comparatively little volatility skew; they're all hot. This does not happen every day, granted, but we see a decent number of them every month.

Multiple Plays

Another indicator of a good play is when when multiple strikes appear on more than one list for a strong stock. If the stock is $20, for example, the 17.5 Call, 20 Call and 22.50 Call plays could all be on some of our lists. All the strikes cannot appear on every list, of course. But as you cruise our various lists, you may notice the same stock appearing over and over, offering different strikes. While a slight volatility skew or "smile" might be evident, the key fact is that time value is high on all call strikes within 10% to 15% of the stock's price. On such a company, IV is hot across all strikes except those really far in and out of the money..

Quality, Quality, Quality

You may be thinking at this point, "Wait a minute, high return means a lot of implied volatility. Doesn't volatility theory suggest that these are some of the riskier stocks on your lists?" Not necesarily. First of all, remember that I said strong companies, not just any company. The strategy above applies only to strong, industry-leading stocks. It is axiomatic in covered call writing that you only write stocks you are willing to own, because if not called out, you WILL own them. Except for some covered call strategies that do not rely on company quality (to be "covered" by me in another issue), you should stick to really good stocks. Here is a round up of a strong stock's features:

• It is an industry leader, not a smaller company following larger stocks
• It is profitable, with sound fundamentals
• Historically low price volatility
• Moves with or better than the industry average and the S&P 500 index
• High levels of institutional ownership
• You're willing to own the stock if uncalled and price is impaired
• The stock is not showing any real technical weakness

The strong company category DOES NOT include companies that are not industry leaders, that are unprofitable or that have a high level of historical volatility. We're talking about the good ones. What about a stock like General Motors, which as I write this is in a long-term price decline working through its problems related to declining sales, labor costs and Delphi pension issues? You know the answer as well as I do... GM is a bit of a gamble, since bad news about it labor talks or resolving the Delphi issue could cause a further sell off.

If uncertain about the company's rank, open our Research Page from the list (click on the stock name) and select the "Industry Snapshot" item from the page menu. This will give you a list of the stocks in the industry, ranked by market capitalization. Also examine the comparative chart at the top of the Industry Snapshot page, which shows the stock's performance compared to its industry group and the S&P 500. The stock should be performing with or better than its industry group. Non-CallWriter members can get this information from sources such as Yahoo Finance. Just click on the profile and look at the company's industry and how it compares to peer companies.

Second, high IV (high premium) simply indicates a market opinion that the underlying stock might move - nothing more. It is only a forecast of price volatility. Based on my years of observation, the fact that a stock lights up several of our covered call lists does not make it any more likely to be volatile in fact on the impending news than one that appears only once on a single list in a lower position. In other words, IV is no more than a guess by Wall Street, which prices options.

Think about this: if IV in and of itself had significant predictive power, we would all just look at volatility skews, buy the options with the highest IV levels, and get rich quick. I know, we're supposed to sell high IV and buy low IV. But if volatility skews really predicted the underlying's price movement, we'd all buy the options with the highest IV, because they would be telling us where the underlying's price is going. I certainly would. It just doesn't work that way. Volatility skews have no statistically meaningful predictive power.

The Wrap-up

I am not saying, nor meaning to imply, that stocks on our covered call lists other than "strong" companies should be ignored. Nor am I saying that plays appearing below, say, the top 5 positions on a list can't be perfectly good trades; they can. This article simply is focused on the best companies and highest returns. There are many approaches to writing covered calls, and this is only one of them. For those of you who aren't CallWriter members, this trade selection strategy can be used with any covered call lists ranked by return.

Here is a recap of today's discussion about list position and strong companies:

• GOOD: High return on one of our mainstream lists
• BETTER:  High return on S&P 100 or Nasdaq 100 and an All-Markets list
• MUCH BETTER: Also a high return on DITM or DOTM lists
• BEST: Multiple strikes appear across the lists

Why do strong stocks showing the kind of high call premiums discussed above do so well as covered call trades? The flippant answer is that the market gives call premium away, but believe me, there is just as much truth as flippancy in that statement. The simple fact is that the best companies' stock prices don't usually skitter around much, whether IV currently is high or not. When option premium is quite high (overvalued) on a strong stock, Wall Street is merely collecting a speculation tax from directional traders.

Someone has to sell all those calls to the speculators. Will it be you?

Short Straddles

Question:  I recently read a book written in the 70's about trading securities options, which stated that selling straddles produced better results than writing covered calls. I was thinking of finding as many stagnant stocks as possible, and writing straddles on them just prior to expiration, to make a quick return. Obviously, this is a risky strategy...have you ever atempted this?

Answer:  Nope. A short straddle is a combination of a naked call and a naked put that are at the money or close to the money. A perfect example of a short straddle would be to sell the 20 Put and 20 Call when the stock is at $20. A more realistic example would be to write the 20 Put and 22.50 Call when the stock is $21. Consistently successful naked writers tend to sell options that are at least 5% out of the money, preferably 10%, in order to allow room for the stock to move. Selling a short strangle (both put and call strikes are well out of the money) makes a far better trade, in my opinion - one with a much higher probability of success. A short put assumes the stock will hold price or go up; the short call assumes the stock will hold price or decline. Maximum profitability on a short straddle (or strangle) requires the stock to stay in the zone between the two short option strikes. The narrower that sweet spot, the more likely that the stock price will oscillate out of it. Obviously, only a stock that is trading in a very narrow range will fit the bill.

Consider: only a small percentage of traders would be allowed to write even a naked call, due to the account size and experience level required. Though a naked put is not that risky (after all, a covered call is just a synthetic way of creating a naked put), brokers do not lightly allow its use.

For those drawn to this strategy, it is possible to use complementary spreads to box the stock in instead of writing naked. For example, the trader could construct a bear call spread above the stock price and a bull put spread below it. Using the example above with the stock at $21, the trader could put on a Short 22.50 Call/Long 25 Call bear spread, and a Short 20 Put/Long 17.50 Put bull spread, both of which are credit spreads. It would look like this:

Prices of course are purely hypothetical (and don't take commissions into account), but pretty close to real examples over the years. In a later issue I will explore the "short straddle spread" (box spreads) in more detail. The return from using spreads would be much smaller than writing naked, but I believe it would be much safer, also - and a broker will actually let you do it!