August 3, 2006

Call Writing Techniques and Styles
by John Brasher, CallWriter Publisher

Many writers discus covered call writing as though there were only one way of doing it. They assume (and rather unimaginatively) that traders either execute a basic vanilla buy-write or write calls on a portfolio of existing stocks. But in my nearly 55 years I've learned that people rush to give advice about things they know little about. Let's look at how real covered call writers do it. There is a style of covered call writing for almost every personality and trading style.

One knock frequently heard about covered writing is not that it is conservative but that it is, well, boring. I don't find making money boring, but some do. What most people fail to realize is that there are many styles of covered writing, all the way from Rip-van-winkle strategies to active trading to strategies that are too white-knuckle for me. My point is not that any of these styles are good or bad, or right or wrong; merely that they are styles. Like a boxer or downhill ski racer, every good trader selects a strategy and style that is in sync with his or her personality. Anything else won't work for long and will not be much fun in any event. Without further ado, let's dive in to some of the most common styles of covered call writing... The Active Writer Wall Street does not give money away, so option premium gets high for a reason. The reason frequently is that the market is awaiting the resolution of an impending event (I call them "volatility events") affecting the company. The event may be resolution of a lawsuit or union vote, an imminent earnings announcement, results of a clinical trial and so on. Sometimes the event is one of great magnitude, more usually not. Options may also be high because the underlying stock is highly volatile, or is recently volatile (the stock may be responding positively or adversely to recent news). As you know, high premium implies - but does not forecast - volatility in stock price. Most stocks on our Real Time Lists™ of the highest-returning covered call trades don't move that much when the volatility event arrives. But once the event passes uneventfully, the premium returns to more normal levels. When this happens it is possible to buy back the calls far more cheaply than the premium gotten from their sale, even if the stock price is the same or higher. This adjustment sometimes makes it possible to close the trade at an acceptable profit level, frequently at an even better profit level than originally anticipated. Active writers watch trades carefully in order to advantageously close them with a profit when possible. This enables the trader to redeploy capital into new trades before expiration, compounding returns faster. They are getting, in banker parlance, a faster "turn" on their trading capital. Closing a trade early of course does not mean the trader has to instantly find a new trade. Some traders will get as many trades in as possible with the same dollars and some are less inclined to hunt up new trades. The Laid Back Trader This trader is not looking to maximize monthly returns. A consistent return of two percent or so a month is fine with this trader, who likes to pick conservative stocks and let them go to expiration. This trader frequently will not close a trade early even if an acceptable profit is available, nor modify the trade to catch an up move in the stock. In fact this trader doesn't check stock prices very often, sometimes not even once a day. There is nothing wrong with this style, and no rule commands us to milk every penny out of trades. This style trades off potentially higher returns (which absorb more of your time) for more personal time. This is a favored approach for those too busy to spend time on trades unless attention is required by an adverse move in the underlying stock. It is also favored by those who would rather spend their days fishing or playing with grandchildren. This method definitely puts a lot of weight on stock selection, and these traders tend to favor large defensive stocks, meaning those people buy less for their upside potential than for the safety factor.  The laid back trader would start with CallWriter's S&P 100 list, looking for the most hammer-safe stocks not facing a major volatility event. [I'm not suggesting any trading is "safe" - just that some stocks tend to be more stable than others.] This trader picks top-notch stocks, lets them go to expiration and sells the stocks when called. When not called out, the trader either re-writes the stock or sells the stock to get into a better trade. This style involves low stress and a low activity level - meaning as little time as possible is spent picking and managing trades. Every minute spent trading is a minute that the trader doesn't have a hook in the water. Another benefit of this style is that the stocks used are not historically volatile and tend not to move a lot, or very fast, meaning that it tends to be easier to react to moves in the stock. If the stock is down the trader just keeps writing it. The Deep Trader First cousin to the laid back trader is the deep in the money (ITM) trader, who concentrates on writing calls that are at least 10% ITM. The returns tend to be lower by at least one to two points than at-the-money (ATM) calls on the same stocks, but there is a method to this trader's madness. Although the return may be lower, the deeply ITM call offers the biggest premium and thus the most downside protection against a pullback in the stock. In fact, deeply ITM writes are one of the prime methods I use to write in a dropping bear market. This strategy can easily yield 2%-3% a month. Not just any stock will do, of course, since a stock that drops 50% is no bargain under any circumstances. Thus deeply ITM writes are no license to let your trade selection fall apart. But by concentrating on the biggest and best stocks, the ITM technique is among the lowest-risk ways to write covered calls. A big benefit is that the trader is far more likely to be called out of the shares, which means that there is no necessity to deal with a stock that was not called out and may not offer particularly good premium in the next option cycle. The typical ATM list of covered call trades will not usually include many of these trades. You really need a list devoted to ITM trades in order to find them. CallWriter's Real Time Lists™ include a list of Deep In the Money trades, which are at least 10% in the money. Technical Writers This trader tends to write out of the money (OTM) and focus on stocks with strong technicals that are likely to advance enough by expiration to get called out at the OTM strike price. There are many chart patterns that can qualify for the technical writer, far too many to discuss here. The key is a technical pattern that holds the promise of enough of a movement by expiration to get the stock called out at the OTM strike. Interestingly, these writes can be found even in a dropping market, just as bad trades can be found in a great bull market. There is a speculative element to this style, of course, since the OTM writer is taking the smallest premium (compared to ATM and ITM calls) and thus getting the smallest downside protection. OTM writing rewards good technical analysis ability, without a doubt. This trader will often be wrong, but also will often be right. Returns will vary; they're great when called out, mediocre sometimes on trades not called out. When people claim to be averaging better than 5% a month in their buy-writing returns, they usually are using some variant of this strategy. Some covered call teachers say to write OTM calls in rising markets and ITM calls in falling markets. Generally, but only very generally, I agree with this. However, some stocks underperform a rising market, and some far outperform a falling market. Don't construct any trade based on such cosmic generalities. Look at the market, the industry and the stock. They will tell you which call to write. (It is something I go into detail about in my seminars) A variant of this strategy is to write half of the call contracts ATM and the other half OTM, resulting in a blended write with an effective strike somewhere between the ATM and OTM strikes. For example, when the stock is $30, you might write half the calls at the 30 strike and half at the 32.5 or 35 strike. The technical writer also is the one who tends to roll up (buy back the short calls and sell calls with a higher strike price) in order to catch more of the price increase on a moving stock. This is not a good or bad technique, just a technique. It is great when it works, not so great when it doesn't. But everyone tries it sooner or later. Good technical analystss can do quite well with it. CallWriter's Real Time Lists™ include a list of Deep Out of the Money trades, which are at least 10% out of the money. This list is important, because even if you like an OTM strategy, you must first be able to find them. The Leggy Writer Most covered writers for the most part use the "buy-write" technique, which simply means to write the calls when the stock is purchased. Modern trading platforms usually allow the trade to be entered so that the stock purchase and call write legs are done simultaneously. An alternative writing method to the buy-write is the "legging in" technique in which the writer buys an advancing stock and writes OTM calls days or even weeks later, after the stock has further increased in price. This trick can really supercharge returns. It can be viewed as a variant of the technical writing strategy, since it requires a stock that actually is moving. This writer lets the stock do all the work and simply waits for further price appreciation to poach a larger premium. Using this technique can double or triple the return in the trade, frequently even if the trader is not called out of the stock. When the stock actually is advancing (perhaps reacting to previous news), the call premium can be quite high. The reason is that the market does not have to wait and see if the stock will move - it is moving already. LEAPS Writers These traders purchase the underlying stock (not LEAPS calls) and write LEAPS calls against the shares, instead of writing the current-month calls. They may in fact sell any call three or more months out. They are not making maximum use of time decay, which is greatest in the last 30 days before expiration, but are getting a much higher premium with great time value. These are some of the lowest-maintenance trades of all, since stock prices are only checked a couple of times a week. These writers understand that the stock will likely fluctuate with market and industry movements and do not worry about it; although they will modify a trade if it is advantageous to do so. These writes can be OTM, ATM or ITM, depending on your perception of the direction the market and the stock will take, and also depending on your own personality traits. However, the ITM strike yields the highest premium and moves most with the stock price (has the highest delta). On the other hand, if you see the stock increasing meaningfully over the life of the calls, it makes sense to write OTM. This strategy does not offer a monthly return, since the writer expects to be in the trade possibly months. And it offers on its face a much lower return than a monthly writing strategy, because the amount of premium obtained per month gets progressively smaller the further out in time you write (my term for it is premium compression). However, many times these trades can be closed early for a great return. And when an OTM write works well, it still can be a pretty impressive return. For this strategy you want top-notch stocks that are in a major uptrend (on a weekly chart) and have impressive fundamentals. Other indicia of a bright future over the next twelve months are also helpful, such as the company is flush with cash and executing a major stock buyback, or insiders are buying the stock heavily in the open market. There are many other ways to use LEAPS calls, including buying the LEAPS calls instead of the stock, that I will cover in seminars, but space does not permit even a description of them here. Portfolio Writing I almost forgot the portfolio writer, who simply writes calls on stocks in the old portfolio as a means of forcing the stocks to pay a monthly dividend. If you don't want the stock to be called away, you must be ready to either buy back the calls or roll them out (or up and out) to a subsequent month. My favorite technique on a stock in a trading range is to write deep ITM calls when the stock is hitting a major resistance level and can be expected to fall. Better yet, it has already stalled at resistance and is headed back downtown. You sell an ITM call and buy it back when the stock is at a much lower level. Because it costs vastly less to buy back the call then the premium obtained upon sale, you make a profit on closing the call. You don't care about the stock's price falling, because you owned it anyway and it  was falling anyway, whether you wrote calls or not. By writing the ITM call and buying it back, you simply creamed the stock for some premium. NOTE: if you don't buy back the call you canl lose the stock when assigned on the calls. If you don't want to lose the stock, it is not a good idea to write the stock at support, because if it recovers into a new advance, you will be in the position of having to buy it back or roll out to protect the stock The same applies if the stock is in an uptrend. Some portfolio writers like to write longer-term calls that are not really in play as the stock moves around, because they don't need to be closed or rolled out very often. And Even More... These trading styles and techniques are only the tip of the iceberg, of course. Some people combine them or use more than one, depending on the circumstances. Do you know what those circumstances are? There isn't room in this newsletter issue to do more than outline the more common styles and how they work in very general terms. For example, there are those who only write in the last week or so before option expiration. In my upcoming seminar in Orlando, I will be covering some of the most common covered call writing techniques, including those above, and how to execute them. Some of these techniques are not known and not taught by anyone else. NOTE: If you haven't taken my 30-second survey for upcoming seminars (the only way to get a major discount on the price), please take the seminar survey immediately - you also get a killer special report on using insider transactions in covered call writing. I will soon be announcing the details of the first Picking Wall Street's Pocket™ seminar and taking down the survey page. And when I do, the big discount will be gone. Time is running out. LEAP is a registered trademark of the Chicago Board Options Exchange. This issue's Question and Answer: The Covered Call Stop Loss Question:  Have been trading covered calls for 1 year now and struggle with where to set our stop loss. This seems to be our biggest downfall. Should we get out when price drops to our Breakeven (from which many stocks bounce back up) or should we set a stop at say 10% below our cost leaving more room for movement??? Answer: Stock prices oscillate about, and you've hit the major problem of stops being too tight - namely that you can get stopped out of a trade prematurely that ultimately works fine. Stocks frequently pull back to a trend line or 50-day moving average and then recover. This is why I don't like a percentage stop and don't like a stop at breakeven; neither bears any relation to what the stock is doing and the danger it poses, if any. The breakeven in particular just tells you where the stock is in relation to your cost basis; it doesn't actually tell you what to do. I prefer to watch my trades and manage them. Always know where support is for the stock, including not only traditional support levels, but also the 50-day moving average or trendline. I worry less about the breakeven than whether the stock is above support. Stocks will test support; it’s normal and healthy. Obviously, you must take into account the relevance of the support level - how recent, how strong, etc. Until it violates support I am normally inclined to give a good stock the benefit of the doubt. If you are not able to watch the stock, then set the stop below a support level. If the stock violates support, especially when you cannot be on top of it, that is the point to get out. If you write a stock that is far above support, you have an obvious problem. That is, when a support level is so far below the current price that even a stop below support would still result in a meaningful loss, support is not very practical as a gauge for setting the stop. In this case, you would have to set the stop at some percentage point below your cost basis. (See the importance of support levels in covered writing?) If you are able to watch the stock, then you have the option of rolling the calls to a lower strike in the same month or the next month out. By the time the stock gets close to the breakeven point, you should be using my Trade Management Calculator™ to look at the nearest ITM strike to see if a roll down offers any advantage. The key in a dropping stock is WHY it is dropping. Is it falling with the market or its industry, or falling on its own bad news? Many people who panicked when the market corrected in early May did not manage their trades but bolted out of stocks when they slid down far enough. The good stocks have mostly recovered, leaving the traders with perhaps needless losses. Many times on a dropping stock I will either roll down or simply close the call and wait to get a new direction on the stock. True, sometimes it is better to get out of the stock and not chase it. For a stock that looks dangerous or is really scaring you, that is the best course, if only for peace of mind. But it is always smart to reanalyze the trade before rolling down or closing. Otherwise, there is no way to assess your situation and the best move. Simply closing a trade every time the stock pulls back below breakeven will yield a string of small losses on trades that could have been profitable. If you are picking great trades, you won't get in trouble very often.

Good luck and good trading!