September 26, 2006

Covered Call Rule #1
by John Brasher, CallWriter Publisher

People love Top-10 lists, hearing which is the #1; look how well Letterman has done with it. Traders may disagree on which should be Rule No. 1 of covered call writing. But there's no doubt that the rule discussed today has as good a claim to the top spot as any. Violate this rule a few times and you will understand how important it is...

Today we're having a not-so-lighthearted look at one of, if not the, most important rules in covered call writing. It's not a technical rule, not one of these precise-measurement kinds of rules. No, it's a purely common-sense rule. Now that I have you panting to know what my #1 rule is, without further ado, it is: Covered Call Rule No. 1: Like the stock. That's it; like the stock. What it means is that - - assuming you are not called out of the stock - - you would be content to hold the the underlying stock in your portfolio for the medium or long term, if need be. When you do a covered call buy-write (buy the stock, write the call), you of course own the stock. But we expect to be called out, keeping the premium and losing the stock for a nice return. But if you are not called out, you continue to hold the stock, and if the stock price is down, your choices essentially are sell it for a loss or hold the stock for better times, continuing to write calls on it. Ah, but that's the hitch. It is a poor practice to hold a covered call stock after expiration just because it is down, just because you don't want to take a loss. A low-quality stock may hurt you far worse in the future if you hold it. It is wise to hold only the high-quality stocks - really, those you would be happy to stick in your portfolio. Liking the stock means simply that you would be content to hold it for an extended period. When you hold a stock, it IS in your portfolio. With a tip of the hat (and sincere apologies) to Jeff Foxworthy... If you feel the need to keep asking trader friends what they think of the stock... you didn't like the stock. If your knuckles are white and you're dying for the trade to be over and be out of the stock... you didn't like the stock. If you feel like puking when you realize the stock was down at expiration and you weren't called out... you didn't like the stock. If you wouldn't want to be caught dead with this stock in your portfolio... you didn't like the stock. If... well, you get the picture. It's About You, Not Anything Else I didn't invent this rule and don't know who did (Wade Cook popularized the concept), but boy did I learn the power of it. What I like about the rule is that it expresses a deep human truth without resort to technical or mathematical information that makes any attempt to quantify the value or prospects of the stock. Therefore I'm not saying you should like the stock if it is above the 200-day moving average, or has a high Zacks rating, or has high earnings-per-share growth, or anything of the sort. Probably no two investors have exactly the same stocks in their portfolio, so opinions can differ radically. By "like the stock" I mean that YOU should like and respect the stock enough to be content to hold it in your portfolio if not called out. I might not like the stock so well, or your brother-in-law the stock expert might not like it, but the stock is not my portfolio or his, is it? It's YOUR portfolio we're talking about. Writing a covered call on a stock you're not willing to hold is the single biggest mistake I see new and even experienced covered writers make. This is a gut-feeling issue, friends, but also more than that. The fact that you would be content to own the stock for a possibly lengthy period of time if not assigned is a very important litmus test. When we are nervous, fearful or disdainful about a stock, it is our subconscious warning us. This is not just psychological mumbo-jumbo, either. On some subliminal level, we know a stock is flighty, that its quality is low, that we haven't really analyzed it, that it is grossly overpriced... whatever. Sometimes, it's not a subliminal feeling at all - we know perfectly well the stock is garbage and write it anyway, hoping or assuming we'll get away with it before the market gives the stock its come-uppance. Conversely, when you like and respect the stock, you just feel better about your decision and are far less likely to second-guess yourself and make a panicky decision. Put in movie terms: if love means never having to say you're sorry, then liking the stock means never having to say you're sorry you bought the damn thing. It's bad enough to have a bad trade without also feeling the need to beat ourselves up - and we all do it. Stick with stocks you're happy as a clam to own. Knowledge is Power, But Ignorance Is not Bliss All this naturally assumes you know something about the stock, of course, that you know why you like it. How else could you be happy to have it join your portfolio? These warm feelings about a stock should be based on knowledge. Whether you know the stock and follow its fortunes, or whether you have done the proper homework the proper way (like CallWriter teaches) you can only truly like a stock, as I use the term, when you know it. Anything less than real knowledge is, well... less. It is a real mistake to figure that, even though it is a stock you'd never be caught dead holding, you'll just cream it for a few easy premium bucks by writing calls on it. Maybe it's just my fevered perspective, but it seems that it's almost always the ones we would never want to be stuck with - the ones we don't really like - that hurt us. Almost every time a stock has hurt me, what I knew in all honesty was that I knew better. In picking covered call stocks, ignorance decidedly is not bliss. Every time we don't do our analysis on a stock and don't know the stock, we're ignorant. This is not disciplined trading, and this is not "liking" the stock. Good Stocks vs. Bad Stocks The bad ones tend to stay bad: The flighty little tech stock that drops from $30 to $10 probably isn'tt coming back anytime soon, if ever - it had its overpriced day in the sun - and you could be in it for many years. It might, but you certainly can't count on it. You can sell $10 Calls on it every month for 0.30 or so as long as you want, but that is a deep hole - deduct just trade costs and taxes on short-term gains and see how you'd do. On the other hand, the good stocks are no sweat. We have a comfort level on those stocks that is spine-deep, because we know we bought quality. A hallmark of quality is that things of quality last. Just as fashions come back in style, a really good company will have its day again - it's an investment, in other words. And even though covered call writers are not really investors, per se, it becomes a good investment that you can continue to sell calls on as long as you own it. Why? The good ones tend to stay good: and thus they come back. Even stolid blue chips like WalMart can take a hit. But they come back. And you can cream them regularly for premium in the process of getting even. Exxon might be down, but do you really think the petroleum business suddenly became unprofitable or its prospects have more than momentarily dimmed? Timing Timing is not so important. Suppose you really like the stock, but now is not the time you would pick to buy it, ideally. Maybe you would like it better at a lower price. Maybe for some other reason now is not the perfect entry time. The question is, if you are not assigned, whether you will be annoyed, apprehensive or terrified that you still own the stock. In other words, it is about comfort level, not stock timing. If the timing is so off that you just don't like the stock right now, then you've answered your own question. Timing or no timing, don't get fancy. You either like the stock or you don't. If you start quibbling with yourself and have trouble making up your mind, pass on the trade. You don't like it enough. That's Really It? If you're saying to yourself, "That's it, that's Rule No. 1? Like the stock?" - the answer is yup. This rule does not tell you how to analyze stocks or provide any criteria for evaluating them. And it is not a way of saying that it's OK to fill up your portfolio with poor-quality stocks that you happen to like. Remember: knowledge. Whatever you process or criteria for evaluating stocks as possible medium- to long-term investments, if you wouldn't be willing to hold the stock for an extended period, don't write covered calls on it. There are many powerful rules that relate to evaluating and picking covered call trades, all rational and all time-tested. But you would be surprised how powerful my Rule No. 1 is. Do your homework and stick with stocks you have researched or know well and are willing to own for an extended period; you'll be surprised how much better your results are.

Good luck and good trading!