March 4, 2004

Ways to profit from covered calls
By John Brasher, CallWriter Publisher

No subject trading related subject is dearer to our hearts at CallWriter than that of money management. Money management is a large subject, since it concerns protecting your money by active risk management. And nothing is more central to money management than the initial question of how much money should you trade in the first place, and how much money should you allocate per trade. But in this article we present some plain-sense ideas on how to calculate the amount of money covered call investing requires and whether to have only one or multiple trades open at the same time.

For anyone not familiar with covered calls, they are simple: you buy shares of stock and simultaneously sell call options ("calls") on them, and the price you get for selling the calls (the "premium") goes into your pocket as income. If the calls you sold are exercised, you are obligated to sell the stock at the calls' exercise price, which is known as being "called out" of the stock, or as being "assigned." Because you own the stock underlying the calls, the calls are "covered" and you have them available for delivery to the buyer if the calls are exercised - - if you didn't own the stock, the calls would be naked. If you are not called out of the stock when the calls expire, you either sell the stock or sell more call options on the stock the next month for more premium income.

This is the basic strategy, and it has worked since standardized options came into existence in the 1970s. Every month you buy one or more stocks, write calls on them for income and then sell the stock, either when you are called out or at expiration. Or if the stock is still carrying high premium consider selling more calls the following month. Generally, the best return is made from writing the at-the-money (ATM) calls, which is the call that is the same or almost the same as the stock's price.

You don't have to buy them; you already own them. It is one of the oldest trading axioms that you should only write covered calls on stocks you want (or are willing) to own, since if you are not called out, you will own them. Well, you already own these. Writing covered calls on them makes these stocks produce income for you, like collecting a monthly dividend. This strategy does not produce as much return as the CallWriter Basic Strategy, but it does produce a return. Another way to look at it is that selling calls on portfolio stocks keeps lowering your basis in them.

Comment: We've seen so many calls written on a portfolio stock that the trader owned the stock for free. To collect 40% of the stock basis in call premium is not uncommon.

If you don't want to be called out of the stock for any reason, write out-of-the-money calls. But if you are called out, so what? You can always buy it again.

Stock and option prices will change while you're in the trade. By entering the new stock price and the current cost to buy back the calls (the "asked" price) into our Position Management Calculator™, you can see in an instant if there is more money in letting the position ride or unwinding it. You unwind a position simply by repurchasing the calls sold and then selling the stock. After a trade is unwound, your capital is safely back in your account, ready for another trade!

Comment: Does it work? Of course it does! A few months ago we did a trade in Cirrus Logic (CRUS) in which we wrote an OTM call for a potential return of 5.8% with almost a month left before expiration. Eight days later, CRUS went up and we unwound it for a 5.3% return. A CallWriter member wrote a covered call on OSI Pharmaceuticals (OSIP), which had gone up after the trade was run, and he wrote today asking us if there was any way to pull more profit out of the trade. We put the numbers into our calculator and saw that the trade set up a6.25% return, but the return would increase to 8.11% by unwinding it. This happens all the time.

If the stock moves up while you're in the trade, it sometimes is advantageous to buy back the calls you sold and sell calls with a higher strike price. This is known as rolling up. As in the case of the Tactical Unwind, enter the new price data into the Position Management Calculator to see if there is more potential profit in standing pat, unwinding or rolling up. Sometimes there is more money to be made from rolling up than the original trade presented. Keep in mind that the roll up only yields a bigger return if the stock stays at the new price level or advances further, so do your technical analysis before the roll.

Sometimes it is necessary to roll down, also. This happens when the stock price drops and the stock is showing technical weakness. When the stock has dropped, the calls will be much cheaper to buy back. By rolling down (buying back the calls sold and selling lower-strike calls), you can get more protection by selling an in-the-money call. Rolling down is not a profit strategy but one to protect your investment or minimize a potential loss.

One of the knocks on options is that - unlike stocks - they are not tangible assets and expire, plus they lose value over time. The loss of value over time is known as time decay. Most of the time decay happens in the last 30 days of an option's life, and the most of that in the last few days. If you are a call buyer, time is not on your side, because the asset loses a little value every day and eventually will expire. But time is the call writer's friend. Many experienced call writers will sell a call with 4 - 6 weeks remaining until expiration, then buy it back in the last 10 days at a fraction of the price paid and sell the stock.

Why bother unwinding to profit from time decay instead of letting the calls go to expiration? The reason is that you can put your trading capital back to work in another trade before expiration. But also remember that getting out of the trade terminates your risk, also.

Example: You buy a stock for $20.00 and write the $20 call on it for a $1.15 premium. Then with 9 days left before expiration, the stock is $20.25 and the call can be repurchased for $0.40. Buying back the call still leaves you with a $0.75 profit from writing the calls (1.15 - .40), and you get an additional $0.25 when you sell the stock at the current market price.

Comment: This strategy works best on out-of-the-money calls, which lose the most time value. It also works well on at-the-money calls. However, in-the-money calls do not lose very much value as time progresses, to the time decay strategy does not work for them. Also, this is not a good strategy for volatile stocks, which move too much; it works best on stable stocks.

The time decay strategy is a variant of the Tactical Unwind, but with a difference. The Tactical Unwind is done to pull more profit out of a trade because the stock's price has advanced and the current option prices make the profit possible. The time decay unwind is done in the last week or so before option expiration, and the profit comes from the option's loss of value.

There are other great strategies for naked calls and puts and for option spreads, but those will have to wait for another newsletter.

Tax Note:
If you get called out of a stock at a loss, do not buy the same stock again for 31 days following the date of sale. If you do, IRS will consider it a "wash sale" and will not let you deduct the loss!

Consistent trading success is what CallWriter is all about. We not only show you the fattest trades, we teach you how to analyze them and pick the ones with the highest combination of return and safety. We also show you how to manage your trades after you run them for maximum profitability. We hope you've enjoyed our newsletter!

Good luck and good trading!