The old adage states very clearly that “Timing is Everything.” Now I am pretty sure that this phrase was not originally coined with trading in mind, but let’s face it, it certainly does apply. In fact, if your timing is good in the financial markets you stand a chance to become rich beyond your wildest dream.
That’s the good news.
Of course the reality is that most people over rate their ability to time things in the market. Because we all want to be buy low and sell high there is a natural tendency to want to believe that we can. Its just human nature I guess. Which leads us to:
Jay’s Trading Maxim #306: Human nature can be a detriment to trading success and should be avoided as much as, well, humanly possible.
So since "timing the markets with uncanny accuracy" (how many times have I heard that one?) is pretty gosh darned difficult, most of us have to look for alternate approaches and ways to take advantage of opportunities where we find them. I have often heard the strategy of selling covered call options against an existing stock position described as "free money". This bit of "wisdom" stems from the fact that if you sell a call option against a stock you hold and the stock is below the strike price of the option when the option expires, then the option expires worthless and you get to keep the entire premium. Voila - free money!
Of course, if the stock is above the strike price of the option when the option expires then your stock is called away at the strike price. So if you hold a stock trading at $28 a share, and you sell a call option with a strike price of 30, and prior to option expiration the stock rallies up to say, a bazillion, you will still have to sell your stock at $30 a share - which in this case, would be "kind of a bummer". So the bottom line on covered calls can be summed up as follows:
Jay Trading Maxim #106: Writing covered calls is like finding free money. Except when it's not.
So rather than buying the "free money" adage hook, line and sinker, let's examine a slightly more structured approach.
Jay’ Formula for Selling a Covered Call against an Existing Position
There are essentially four steps – all of which can be as ambiguous or rigidly defined as you’d like:
1) A stock that you hold stages “an advance”
2) Upside momentum “wanes”
3) The stock experiences a “short but sharp advance”
4) A “well out-of-the money” option can be sold and generate a “decent” rate of return
As you can see by looking at the items in quotations in numbers 1 through 4 above, different people will come up with different definitions. So for the sake of clarity, let’s look at just one example.
Figure 1 displays ticker VHC as of 6/19.
Figure 1 – Ticker VHC
As you can see in Figure 1, VHC had:
1) “Staged an advance” – rallying from 20 to 35 in about three months
2) Upside momentum had “waned” – MACD had rolled over to the bearish side
3) There was a “short but sharp advance” – The 3-day RSI popped up above 70
4) At the moment the stock had resistance up above $39 a share and the August 40 call could be sold for $0.85.
With the price of the stock at $33.84, the sale of the July 40 call for $0.85 would generate $85 of income, or 2.5% of the value of the stock. To put it another way:
- As long as the stock did not advance more than 18% in the next 31 days this option would expire worthless and
- The seller would essentially have collected a 2.5% “dividend”.
If an investor could make this trade just 4 times a year then he or she would add 10% to their total return for the stock.
On the flipside, if the stock does rally above 40 by expiration then the stock would be called away at $40 and the investor would keep the $85 of option premium and register a profit of $701 (above any profit that had already accrued before the covered call was written), for a profit of 21.25%.
So how has all of this worked out? See Figure 2.
Figure 2 – Long VHC, Sort VHC July 40 Call
As of 7/12 and with 8 days left until July option expiration, the stock had advanced to $37.77 for a gain of $393 since the close on 6/19. And the July 40 call?
As this is written the option is trading at $0.80 bid/$1.00 asked. What this means is that if the trader in this example wanted to buy back the call at the moment, he would pay $100 ($1.00 x 100 shares) and experience a $15 loss on the sale of the covered call option.
However, there is no real compelling reason for an investor to buy the option back at the moment. If the stock remains below $40 for the next 8 days the July 40 call will lose all of its value and expire worthless, and the investor will keep the entire $85 he or she originally received when the option was sold.
An Alternative Approach
One thing I typically recommend regarding selling covered calls is to sell against less than your entire stock position in order to retain unlimited profit potential. Remember, if you sell a call against a stock you forego any profit potential above and beyond the strike price of the option you sold.
In the VHC example, if you sell the 40 call and the stock goes to $50 you must still sell the stock at $40. So bottom line, if for example, you hold 1,000 shares of stock, sell something less than 10 calls in order to retain unlimited profit potential.
The method I’ve just described can also be used as a profit-taking method. For example, this time let’s assume that the investor hold 1,000 shares of VHC. He could sell five of the July 40 calls and generate 1.25% of income if the stock is below $40 at July expiration. The status of this position as of the close on 7/12 appears in Figure 3.
Figure 3 – Long 1,000 shares of VHC, short 5 July 40 calls
The key thing to note in Figure 3 is that profit potential remains unlimited.
If VHC rallies above 40, then the 5 calls sold will be exercised and the investor would:
-Have 500 shares of stock called away at $40 a share (while keeping the premium received)
-Continue to hold the other 500 shares thus continuing to enjoy unlimited profit potential
As with any strategy there is no “one best way” to write covered calls. Still the method I’ve described here – otherwise known as the “Sell a call when a stock you hold that has been very strong starts to stumble except for a recent short-term pop and you can sell a pretty far out-of-the-money call and still generate at least 2% or more of premium in less than two months” approach (Note to myself: come up with a better name) – seems to make a certain amount of sense.
Staff Writer and Trading Strategist
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