September 7, 2005

Why Write Out-of-the-Money Covered Calls?
by John Brasher, CallWriter Publisher

Writing out-of-the-money covered calls can really supercharge trading returns, IF the stocks written go up enough by expiration day to get called out. Questions we have gotten recently indicate a need to review the rationale for writing out of the money.

I frequently get asked if writing out-of-the-money (OTM) covered calls is safe. When should they be written, or not written? Just as deeply in-the-money calls offer the most premium and downside protection, OTM calls offer the very least. If the stock goes up and you are called out of the OTM call, the return can be huge. They are great when they work! Another problem is that the OTM premium can stay maddeningly high when you have to buy the calls back to close or roll down.

But the major point with OTM call writing is this: they only make sense if you believe, with reason, that the stock is likely to advance enough by expiration day that you will be called out. Period. If the stock is not likely to move up enough, and do it by expiration, the OTM write is a poor decision. So OTM writing comes down to one real question: why do you expect the stock to move up? It is surprising how often I talk to call writers about their OTM trades and they can't tell me why the stock should go up. Obviously, one should have more than just a feeling or hunch. The trade rationale should be based on thorough technical analysis. Fundamental analysis, while important to covered call trading, is not much help in determining the likelihood that the stock will advance enough to be called out in the next few weeks.

The WHY Question

Each time one considers an OTM write, this over-riding WHY question should be answered before the trade trigger is touched. OTM writing can work well if the stock is in an uptrend when the market is flat or, better yet, is itself in an uptrend. One technique is to write stocks that are in an uptrend but have recently pulled back and caught support, either at the trend line or the 50-day moving average - in other words, writing a dip prior to a new advance. The advance off support is a great way to assure being called out. Another good technique is to write stocks trading in a large but fairly stable range (channelling stocks) when they catch support and are beginning a new advance in the range.

Some traders like to write large, profitable companies expected to announce earnings, but this makes the most sense for a short-term covered write if the stock has a history of advancing on positive earnings news; this technique depends on the stock behaving on the upcoming earnings report as it has reacted to earnings reports in the past (and that the company will make its number). Some stocks do not have consistent reactions to earnings reports (or consistent earnings), but some do.

Irrespective of the technical and fundamental justification relied upon, the point is to have one.

So when are stocks poor OTM candidates?

If the stock is trading flat or in a tight range, it is not a good candidate for OTM writing. Even if technical signs indicate a breakout to the upside, a covered call is not the best trade to capitalize on it. And it goes without saying that a stock declining or showing negative signs (negative moving-average crossover, bearish divergence, etc.) is a terrible OTM candidate. Similarly, OTM calls are pretty gutsy in a market decline. Sure, some stocks move up in most market declines, but the tide is against you. Watch out for resistance: even in a good market, OTM calls should never be written when the stock is at or close to resistance - especially a strong resistance level - because a failure at the resistance level is the most likely outcome - and an assumption that a stock will break through the resistance level is merely a gamble. In fact, any chart that suggests a flat price or decline over the trade's expected duration makes a poor OTM candidate.

OTM calls require the underlying stock to actually move. Unlike the ATM call, where the stock can just languish about and still make the trader good returns, the OTM call only works if the stock goes up, and does it on time. This factor does not mean that OTM calls are dangerous, but that more care in trade selection and technical analysis is necessary with them, since the downside cushion offered by ATM and ITM calls just isn't there.

Question:   Do you believe it's true that the key to consistently successful covered call writing is to do all my writing deeply in the money?

Answer:  I disagree. I think in-the-money covered writing is an excellent technique for getting good returns (see my recent article on in-the-money writing), but there are many covered call strategies, and that is only one of them. There are three controllable components to covered call writing - indeed, all trading. They are: trade selection, trade planning and trade management. (I consider money management to be subsumed within trade planning and management.) Covered call writers who plan trades simply do better. By planning, I am referring to selecting the strike and expiration month, deciding the trade size, determining the stop and profit level, etc. Management is vital, also, since trades will sometimes require managing for maximum profitability or to pull one's chestnuts out of the fire.

But to my mind, the key to successful and consistent covered call writing is trade selection. This is easily 60% or more of success. One who picks lousy trades, or who picks trades just for the return without regard to other factors, won't be in the game long. It is not difficult to select good covered call trades, although it does take a bit of time and effort... as does all trading. It simply is not that difficult, and gets easier - a lot easier - with practice. We provide this education to CallWriter members free, but however one acquires the knowledge, consistent returns require making good trade choices.

Good luck and good trading!