June 5, 2007

Building a Covered Call Trade
by John Brasher, CallWriter Publisher

That's a pretty straightforward title, I think. Build it right if you want the best results - that applies to just about every endeavor, covered calls as well. Today's article lays out some examples of how and why to construct a covered call.

Trade Planning - a/k/a Building the Trade A covered call write should be constructed to match the trade’s underpinning strategy and your expectations for the stock over the trade’s expected duration. By the strategy, I mean of course the strategy selected by you. By expectations, I refer of course to technical expectations for the stock, perhaps its industry and perhaps even the market. By now you know that you should like, respect and be willing to marry the stock from a fundamental standpoint. But unless you want to just spin the bottle, technical analysis will - in light of where premium is found - suggest which call strike call strike to write, and which expiration month. It will also indicate whether a protective put should be purchased. When constructing a covered call trade, thoroughness would include considering the following factors: The quality of the stock. - Stick with excellent, established and profitable companies Your technical evaluation of the stock and perhaps its industry. - Likely direction over the trade's anticipated duration Support and resistance levels. - Be clear where they are and their respective strengths The level or return desired (and available) for the risk undertaken. - Is premium accptable? The more risk or uncertainty, demand a higher return Your preferred trade duration. - You are in control of this, to the extent a trader controls anything Level of implied volatility (IV) and impending news. - High IV on a mid-cap or smaller company: you'd better know the news Your trade strategy: - Capturing time decay, playing implied volatility, timing a move, etc. Don't view these trade planning points as a list to memorize; they are simply common-sense considerations. If you like short-term trades, for example, either write short-term trades from the outset or write longer-term calls with an expectation of buying them back on a dip in stock price or a collapse in implied volatility, not intending to stay in the trade through call expiration. Sure, you might wind up being in the trade longer than planned if events so transpire, but we are just planning a trade here, not ordering the cosmos. Suppose the fat option premium implies high volatility but the stock is solid and you doubt it will move significantly; it makes sense to design a trade that will capture the IV collapse and allow a quick close. On the other hand, if the news event driving IV is of a dangerous nature, you must either buy a protective put or pass on the trade. An easy and common example: when a strongly trending stock has pulled back to test support or is at the bottom of a well-defined range, a great trade can be built to take advantage of the snapback off support. None of this requires a crystal ball; leave it in the closet. It is just a matter of determining the best strategy for a trade and whether the best call strikes/months for that strategy offer acceptably fat premium. For example, if you are only interested in deeply ITM calls and they offer no return, move on. If the trade strategy you think is right requires using OTM calls that offer little return, you must either leg in for a better return (trusting the stock's advance to fatten the premium) or pass on the trade. And so it goes. The Role of the Technicals As noted, your strategy and expectations for the stock (your trade rationale), are crucial in proper planning. You will not always be right on direction or other technical reads, but once you have approved the stock as a potential writing candidate, the technical picture heavily dictates the trade's construction. You might ask, isn't this getting dangerously close to directional trading? That argument holds some water, but not much. First, everyone who trades, teaches or picks covered calls has to select trades somehow. And when you select a trade, no matter how you evaluate it or read the tea leaves, you are stock picking. If a stock is selling off, would you ignore that? I certainly hope not. And if a stock in a strong industry is in a long-term uptrend (e.g., ATI as I write this), would you treat it like a stock in a tight trading range? Probably not. For those who doubt the viability of using the technicals to construct the trade strategy, what is a better approach? Certainly, the blind application of a single strategy to all trades (e.g., writing everything OTM no matter what) is not a better approach, nor is the rigid application of any formula. A directional trader bases the strategy solely, or almost solely, on the technicals. That's not what I do, and I suggest you not do it, either. For the savvy covered writer, the technicals merely inform the logic of a trade that meets strong fundamental criteria. Whoops, isn't all this talk about technicals really backing up into the subject of trade selection? Yes and no. While reviewing a trade candidate's technical picture, you should also be thinking how you would write the trade; your strategy. They are not really separate analyses. Your technical review will dictate whether a trade is possible and what the strategy should be. Your trade planning process will reveal whether the premium makes it worthwhile. Put differently, if during the technical review you like the stock, what, precisely, did you like? And what you liked is usually what you should do. Hmmm, you might say to yourself - this stock of an excellent company is reaching the bottom of a well-defined trading range and seems poised to head back up in its range. You just stated your trade strategy, didn't you? You should not blithely trust the chart, of course, and should not bet unborn children on it. But ignoring the plain evidence of the chart also is faintly ridiculous. If nothing else, using technical analysis will improve your returns because it improves trade construction to take advantage of what is happening in the real world. If you lack technical skill (get some, I strongly advise) or have no faith in your reads, stick with a conservative covered call strategy. But with experience you will see how trades go, and you'll see missed opportunities, missed returns, that were easily yours with the proper trade construction. We all go through this process, and there is no better learning. But I assure you, and I have a lot of experience with my trading and that of many CallWriter members upon which to base this statement, that using solid technical analysis will help you to build better, more profitable trades and avoid some of the venomous ones. Once you have eliminated negative technical pictures, and known, impending news events, the only things left to hurt you in a trade are bad luck - the unforeseeable asteroid strikes of the market. They don't happen too often and can't be foretold, so we are best advised to stick with the proven elements of trade planning. Some Trade Construction Examples So the technicals play an important role in how we plan and build the trade and set the stage for rational trade expectations. Next we must select a strategy that capitalizes on the technical picture and available premium. For example, are you writing extremely high implied volatility (IV) in the expectation that IV will collapse? Are you writing with an expectation that the stock soon will pull back to a support level and rebound? Is your goal to maximize the use of time decay? Like the stock but are concerned about a sell-off or a pull back in the market? These are the kinds of real-world concerns that covered call writers must take into account. Now let's take a look at some common-sense approaches to building the covered call. The following examples illustrate how your strategy and reasonable expectations for the stock affect trade construction: 1. Writing high implied volatility in expectation of an IV collapse: • Write an ATM or OTM call in the second or third expiration month out in order to get more premium, since the time value of those calls further out will collapse also when IV falls. If the stock's technical picture is negative, this strategy is not indicated. 2. You expect a trending stock to pull back to support, then rebound: • Write a deeply ITM call in the expectation of buying the call back at a profit when the stock pulls back. Writing a month further out will increase time value. Then sell the option again after the stock snaps back off support – that is, trade the call with the stock’s movement. If wrong on the stock's movement, you can close the short call or roll out. 3. Maximizing time decay: • Writing current-month calls takes maximum advantage of time decay. Close to expiration, close the trade for a profit, or roll the calls out to the next month if premium and the trade's outlook both are acceptable. 4. You expect an imminent move up in the stock: • Write OTM calls in the current month or next month. If the stock moves up but not enough to get called by expiration, you are still ahead of the game. • Alternatively, leg in to the trade – buy the stock and wait to write the calls on the stock’s advance. By waiting and writing an ATM or OTM call once the stock has moved up an acceptable amount, the premium written will be much larger. • Alternative 3: do a blended write, also known as scaling in, buying the stock and writing some calls now and some when the stock advances. 5. An excellent stock is approaching a major resistance level: • The stock can be expected to pull back from resistance, so you write a deeply ITM call, expecting to buy it back profitably as the stock falls. We buy an ITM put with a strike at or above the resistance level a month or two further out than the call and sell the put at a profit as it gains with the stock’s pullback. This is not an ideal technical picture, unless you already own the stock or like it and are willing to keep it. 6. The industry or overall market is pulling back, or you fear a pull back: • One alternative is to hedge bets by writing a deeply ITM call, and you can add an OTM protective put for the same expiration month if you fear a catastrophic collapse in the stock. Sure, the put eats up some call premium and does not confer complete protection, but it may be worth it for peace of mind. • Another alternative is to write ATM calls for maximum premium and also purchase an ATM or ITM put several months out (look for very low time value in the put), which will add significant protection and also adds another potential profit source. Once the put's time value is recouped, the call writes will get into profit territory. 7. You seek a longer-term write but prefer not to trade actively: • Pick very high-quality, stable stocks. Write long-term ITM or ATM calls, either LEAPS or calls with a 6-month or greater expiration that reduce the cost basis to a level at or below major long-term support. 8. You seek a longer-term write and will accept low returns for low or no risk: • Use the same trade picks as in the prior example, but in addition buy an OTM put with the same expiration. The return may not exceed 10% annually but the trade can be built to risk only a couple of percent of the net debit. Experienced traders might accept greater risk by buying a further OTM put slightly above major long-term support. I believe that upon technical review, the stock will tell you what to do. For example, it is generally a bad practice to write OTM calls – which offer lower premium compared to ATM calls and the lowest downside protection, yet are maddeningly slow to lose value if you have to buy them back on the stock's pullback - unless you believe based on the best evidence that the stock will increase in value during the trade's planned duration. So if you like writing OTM, look for stocks in this technical posture. If a stock is not in this posture, don't write it OTM unless premium is high and another OTM strategy works (e.g., your goal is to capture the collapse of impled volatility and the stock's technical picture is not actually negative); select another strategy. This is trade construction soundly informed by the charts, not directional trading. As such, we are merely employing good old horse sense in a rational attempt to sweat the most out of the trade. These are by no means all of the possible scenarios and strategies for planning covered call writes, nor are all the potentially good strategies for the above situations necessarily presented. They do illustrate, however, how I plan and construct the covered call based on real-world considerations. I want everyone to adopt a powerful (empowered) and flexible approach to covered writing that is grounded in common sense.

Good luck and good trading!