June 24, 2004

Maximizing Covered Call Returns
by John Brasher, CallWriter Publisher
 

Writing covered calls (and sister strategies, such as call and put spreads) is a strategy designed to produce a strong monthly income of 3%-5% without margin. Remember, stocks can only do three possible things: decline, advance or hold their price. Many hot investment strategies win only if the stock does one of the three things: your odds of winning are 1 of 3. Covered calls, however, win if the stock holds its price or advances, which gives you a 2 out of 3 chance to win. Which do you like better?

Which approach is for you?

There are several approaches to covered writing, and some are much more productive than others. Here are some strategies for maximizing returns that we have found to be consistently productive and consistently doable.

Buy-Writes
These are covered calls in which you buy the stock and simultaneously sell the call options, as opposed to writing calls on stocks that you happen already to own. The strategy is to find stocks that pay high returns on covered calls and write them. Once the call expires, you either write the stock again or sell it and buy a better covered call candidate, always in a quest for sustainable high returns. This is the entire rationale for the existence of our website, CallWriter. We have created our Real Time Lists™ of the highest-returning covered call options precisely for the buy-write strategy. Getting a consistent 3%-5% monthly return, without margin, is perfectly attainable and you can find such candidates many ways, it's just our lists make it incredibly easy. Getting 6%-10% is no problem if you are willing to use margin, but we advise traders to get some experience first before using margin.

Write OTM on Movers
Some investors like to buy calls on stocks that they think likely to move. It's not a bad strategy, but (1) it is a debit trade, meaning net out of pocket to you, and (2) it loses if the stock goes down or simply doesn't move up - or moves up only slightly. You can buy a call further out-of-the-money (OTM), which will be cheaper but even less likely to bingo. But there is a covered call strategy that accomplishes the same thing and puts money in your pocket - writing OTM calls. Not too far OTM, just slightly OTM. For example, if the stock is $19, write the 20 Call. If it is $21, write the $22.50 call.

Why? If you have correctly predicted that the stock will be above your OTM strike price at expiration, you not only get the flat return from writing the call, you also get the strike price that is higher than the price you paid for the stock. So if you pay $19 for the stock, write the 20 Call for $1 and get called out at $20, your total called return is $2 - which is over 10% (without margin). If you are a good technical analyst and adept at picking stocks about to move, the OTM strategy will be more productive than writing at-the-money (ATM) calls or buying calls. CallWriter also offers OTM Real Time Lists™ that find these very candidates, each one guaranteed to be at least 10% out of the money. (For more on our OTM and ITM list, see below.)

Channeling Stocks
Some stocks regularly trade in a channel, some have only been in a channel for few months. "Channeling" refers to a stock that is consolidating and trading within well-defined support and resistance ranges. A favorite technique is to write calls on stocks at the bottom of the channel (let them bounce off support, please) in the expectation that they will channel again up to the resistance level. In fact, double your pleasure and double your fun by writing OTM calls on stocks low in their channel, knowing there is a high likelihood they will rise again in the channel, almost assuring exercise. You still have to find channeling stocks with high returns, since the mere fact that a stock is trading in a channel doesn't mean it will offer high call returns.

Once the stocks test resistance and start back down, this is the time to sell naked calls or put on a bear call spread (described below) and work the stock on both moves. In fact, some investors like to write deep in-the-money calls on channeling stocks at the top or in the middle of the channel. The idea is to capture as much premium as possible in the expectation that the stock will drop in its established channel, but not enough to hurt the writer.

Spread that Call
We think of a call being covered by ownership of the underlying stock. But there is another way to cover a call, and that is buying a call with a higher strike. It is possible to sell a call covered by another call - for a net credit. In other words, you get paid to run the trade! And you don't have to tie up your cash buying the stock. This trade is a call spread, and the "spread" refers to the difference between the two strikes. A credit spread built with calls is known as a bear call spread and it depends for success on the stock either holding its price or going down (unlike a traditional covered call, in which you don't want the stock to go down). The strike purchased must be for the same or longer duration as the call sold.

Example:  When the stock is $19, you could sell the 20 Call for $1. This is a return slightly greater than 5%. If you are called out at $20, the return is even higher. But you have to tie up $19 per share in the underlying stock. Suppose instead of buying the stock, you sold the 20 Call and bought the 22.50 call for $0.15. You net $0.85 per share $1.00 - $0.15), but have no capital tied up in the stock. The 20 call is covered, because if you get called out of the stock at $20, you can buy the stock at $22.50. This is a credit trade, since you put money in your pocket. Your total risk is the difference in the two strikes, less the credit received; in this example $1.65 ($22.50 - $20 - $0.85 received).

In the above example, the investor is risking $1.65 to make $0.85, whereas the traditional covered call writer in the same example would be risking $19 to make $1. Which strategy sounds better? As with traditional covered call writing, you are looking for the highest premiums, but you are looking for a stock likely to fall. Another great strategy for channeling stocks! Put on the bear call spread at the top, then write a bull put spread (exact opposite strategy using puts - sell the higher, buy the lower) at the bottom.

Some Low-Yield Covered Call Strategies

You Own 'Em, So Write 'Em
The simplest strategy, and generally the one that yields the worst return, is to simply write calls against stocks that are in your portfolio. Their returns may be low or high, but you already own them. But while it is a low-yield strategy, its statistical risk is just as high as buying stocks every month and writing covered calls on them, since they haven't made the stock yet that can't go down. In fact, if the stock is down substantially from where you bought it, selling a covered call could result in getting assigned and having the stock called away, which would lock in a loss. But if you own a stock and intend to keep it, writing calls on it can be a sound strategy to produce regular income from otherwise dormant stock.

Stodgy Stocks
Another low-yield strategy is to only write calls on household-name stocks, such as those appearing on the CallWriter S&P 100 list. These usually (not always) offer low returns, but are more stable month in and month out than NASDAQ 100 stocks, much less technology stocks. By stodgy, we aren't knocking them, because in a flaky market that is down-trending or rolling, these will on the whole be the safest, albeit not the highest-yielding.

Too Far Out, Man
Calls that are too far out of the money just don't pay enough to be worthwhile. It's hard to make money on calls paying premiums of $0.50 or less. Plus, a stock has to work too hard by moving above a strike price that is too far OTM. And if a stock well out of the money is paying a strong premium, it is really volatile... and you'd better find out why before writing the call.

No Time Premium
Calls that are ATM or OTM are all time premium. But calls that are ITM should have both intrinsic value (the amount the call is in the money) and time value. The time value is where the gravy is on ITM calls. If the $15 call on a $20 stock is going for $5, it's a rip-off. You could sell the stock and get the $5 - which is simply paying you with your own money. The return on this covered call would be -0-. If the premium instead was $6, then the real return would be $1, or 5%. A surprising number of covered call writers haven't figured this out.

Good luck and good trading!