Selecting Good Stock Candidates for Covered Call Writing
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January 8, 2007
Now that we have begun a new trading year, let’s go over some basic tips on how to select attractive stock candidates for the very popular covered call writing technique. As an options trader I personally like to substitute diagonals, out-of the-money call calendars and horizontal spreads as a lower cost alternative to traditional covered call writing, so this information can also be applied to these strategies as well.
First, any stock selected for covered call writing or any one of the substitute strategies should be on an underlying issue that the trader is slightly bullish on, meaning stocks the trader believes will increase in price only slightly during the period before the option expiration date. Also, a stock with some volatility is desirable because it typically means getting a better premium.
Seek out stocks with betas between 1.0 and 1.5. This range is best because a beta less than 1.0 is not very volatile and usually will not pay a very good premium. Betas greater than 1.5 will have a good premium, however its higher volatility increases the probability that the underlying equity will make a sudden big move in either direction. If that move is lower, the position will lose value. If the move is higher the trader suffers opportunity loss by not being able to sell the stock at a higher price as long as you are obligated to hold stock while the covered call position is still intact.
When you find a stock that you like fundamentally wait for a nice retracement before purchasing the stock, as long as the stock has not dropped due to serious bad news on the company. Find out why the price is lower before making a purchase. Once you own the stock, hold it and write a covered call later when the stock price increases.
In addition the trader should select a stock that is close but just below the next higher strike price or in otherwords slightly out-of-the-money. Then write a call at that next closest strike price above the current stock price with one or two months until expiration. This option series will pay a higher premium while reducing the amount of time the trader is obligated to hold the stock. Selling these slightly out-of-the-money calls should offer the best chance at being consistently successful at writing covered calls.
The trader wishing to write covered calls should also become familiar with the behavior of specific stocks and watch them a while before making a purchase. Keep a file on each stock being monitored. Make sure to note any developments as they occur, such as earnings reports, brokerage firm upgrades or downgrades and specific news on the company and its products or services.
In addition, use trendlines to help locate stocks that are potential covered call candidates. If trendlines indicate a trading range or channel then make sure to buy the stock when it has bottomed out at a support price level. Finally, plan on writing covered calls or implementing some of the lower cost option strategy alternatives on the same equity over and over again, month after month and use these strategies as a regular income producing vehicle.
Jeff Neal
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
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