February 25, 2004

When to write covered calls
- and which ones to write -
By John Brasher, CallWriter Publisher

It is high time we addressed one of the most common questions we get, which is: "when is the best time to write covered calls?" The answer is almost any time. The only market in which covered calls are unsafe is a fast-dropping market, although they should not be written on declining stocks, either, in any market. Here is the straight skinny:

One thing that should be emphasized is the fact that you simply cannot ignore the prevailing market trend. If the market is trending down, this fact is more important than the stock's individual direction. That is, a stock will usually counter-trend the overall market for only so long and will correct. And the correction frequently is major. For this reason, we are very hesitant to write a rising stock in a dropping market. Conversely, it is always a mistake to write covered calls on a stock that is dropping in a rising market and showing greater weakness than the market.

One question we always get is how on earth we can advise anyone to write covered calls in a down-trending market. Don't we know you can't do that? Well, we don't. First of all, a downtrend can be anything from a very gentle one to nearly vertical. Second, there are trading-range periods in every down-trending market, during which covered calls are easy to write. Third, the best companies don't lose value like the flaky ones. Priceline may have gone from $70 to $2 in the bull market crash, but WalMart didn't.

Actually, it can be easier to write in a down-trending market than in a channeling (ranging) market. The reason is that a channeling stock will not always turn at the same point. If they always hit the same support and resistance points in the range, writing them would be child's play. But they can pull back well before the last resistance point is reached.

We understand that many of you are more aggressive call writers than we are here at CallWriter. And we also understand that traders have to trade in a style that suits their individual personalities. But we have learned over the years what works best and what works consistently, which is the reason for our conservatism. The hotter you write, the more money you will make... but the more you will give back to the market in the form of losses, too. The name of the game is to KEEP the profits.

For example, compare these two calls on an $18 stock:

Notice in the above example how the percentage of protection conferred by the premium is inversely related to the return. That is, the smaller the return, the greater the protection. This is pretty much generally true of covered calls in all markets. Traders who like to write hot or believe the stock will advance strongly before expiration would opt for the 20 call's extreme return in the event the stock is called out. Many traders would opt for the 17.50 call's high return and smaller downside protection. Traders writing in a declining market or concerned about a pull back would opt for the lower return but far greater protection of the deeply in-the-money 15 call, which protects all the way down to $14.25. It’s a personal philosophy, but we would not hesitate to write the 15, since there is plenty of glory in a 4.16% return for a month or less.

There are many tricks to the covered call writing game. And we have learned the most important ones, which we have distilled into the CallWriter Method and teach to our members. We know how to trade with few and small losses. We are, admittedly, fairly conservative traders. Our approach is not for everyone. We have had people leave our service, thinking we were sissies. But our historical trading average, even through 2000, 2001 and 2002 is slightly better than 4 for 5 winners and 3% to 5% a month, because we are careful.

By observing the essentials of the CallWriter Method and applying trade discipline, you can also make a handsome trading profit every month. Here is probably the best piece of market advice you will ever get:

Getting high trading returns is not difficult -
the hard part is to avoid giving them back to the market!

Good luck and good trading!