Covered Call writing has become the mainstay of my market exposure. It is my bread and butter, so to speak. I’ve implemented this strategy since 2003, dealing mostly with positions on the US stock markets. And while how I approach this strategy has changed very little in more than 10 years, there are some subtle influences that define my successful implementation of this strategy.
In an effort to make this article a little more interesting, I thought I’d compile those trading rules in the form of the 10 Commandments of Covered Call writing. Just like the biblical Ten Commandments, these instructions act as a guideline to those who have faith (in the strategy).
Commandment 1: Thou shalt Know your strategy. Know your approach
Wanting to make money from the markets, and knowing how you make money from the markets are two very different functions. You won’t be able to adopt the Covered Call strategy successfully without knowing what dynamics are and how the strategy reacts to various market conditions.
I’ve taken 10 years to fine tune how I approach the Covered Call. And even with a profound understanding of what action to take, changing market conditions always produce periods of hard decision making.
The more you practice and implement this strategy, the better you will understand its Risk and benefits. Hence, learning from a successful Covered Call writer, and seeking advice from a licensed broker will only help in your development.
Commandment 2: Though Shalt be Patient
The Covered Call strategy is not a short-term, get rich quick approach. Success comes from Time Decay in the option value. Hence, you need time to pass for this strategy to become profitable.
Too often I see traders jumping onto any Covered Call that shows high returns. There is a sweet spot for option writing that produces approximately 2.5% to 3.5% for any given month. This range has a higher probability of success over searching for high premium returns or directional movements.
Have patience to find these trades, especially when market conditions are not suitable for the type of strategy.
Commandment 3: Though Shalt not Risk more for Profit
Money Management is a key to successful investing in the stock market. Placing all your capital onto one trade is no better than going down to the casino and placing all your money on black! You lose, and you will lose big.
Devise a money management plan. For example, if you have $100,000 for investing in the stock market, diversify this into 10 different positions with $10,000 on each trade. Don’t increase any one particular trade because you “think it is a better trade”. Murphy’s law is that it will be this one trade that ends up being the biggest loss of all.
Commandment 4: Remember, consistency is key
Having operated the Covered Call strategy for more than 10 years, I have plenty of statistical data to back up my understanding of this strategy. But extensive studies have also been conducted by the Australian Stock Exchange. The following link will provide you with additional information: http://www.asx.com.au/products/s-and-p-asx-buy-write-index.htm
Bottom line is that in any given month I expect an average win to loss ratio of 80%. That is, out of 10 trades I will have 8 winners and 2 losses. This is over a 5 year period, noting that there will be years where extended Bear markets will show weaker performance, and extended Bull markets will show improved performance.
Your long-term returns will not be based on a single trade. Trades conducted each month, and from year to year will help to provide a guideline on what your expected performance should be.
Commandment 5: Bear witness to your Exit strategy. Don’t hold your trades when markets shift against you.
The greatest Risk of the Covered Call strategy is that share prices will fall. Too often I see traders holding stocks that are trending downwards. Irrespective of the fundamentals of the company, if the share price breaks support, forms a downwards trend or breaches your exit stop, there is a higher probability that it will continue downwards. Why continue holding it?
You must be disciplined to act on your exit strategies no matter what your personal view is of the company. For the times when the share price bounces back, there will be twice as many times when the share price continues falling.
Commandment 6: Revere your analysis and learn from past performance
If you don’t know how to choose a stock for a Covered Call, then you will have to learn. At the same time, you must have confidence in your analysis and decision making process. This comes with time and experience. But realise this, even the professionals sometimes second guess their decisions.
Covered Calls require fundamentally strong companies that have a high probability of holding in a sideways price pattern, or shifting upwards, within a set time-frame. You need to learn how to identify these companies, but also understand what influences there will be during the time-frame you hold the trade.
For example, earnings reports can have a positive or negative influence on stock values. For this reason, I prefer not to enter a Covered Call if that underlying stock is scheduled to release earnings before expiration of the sold call option.
Commandment 7: Though shalt keep records of trading history so as to learn
If you don’t keep records, you won’t know where you make your mistakes. Consistency is key, as previously mentioned, and your statistical history will show you when your approach is performing well, and when it is not. With this data, you can identify weaknesses in your strategy, or at the very least, find comfort in the fact that maybe it was the markets that underperformed, and not your approach to the strategy.
Commandment 8: Covet Time Decay
Covered Call writing is all about Time Decay. That is, we enter a position say 1-month from expiration of the option contracts. And at the end of the month, the option will lose Time Value. If we have sold an option and received say $1.00 per share, if it remains Out of The Money (OTM) on expiration day, then it will be worthless. That is, we retain the $1.00 per share that we originally received for selling the Covered Call.
But writing Covered Calls for longer time-frames does not necessarily mean better returns. Statistical data proves that the ideal window for writing Covered Calls is between 30 and 45 days from option expiration. This is where the majority of Time Decay will occur.
Commandment 9: Honour your goals. Know what is achievable, what is realistic, and what is a dream.
Not only do you need to know how to adopt the strategy and how to manage it, but you need to have a broader game plan in place. Simply “making money” is not the key. You need to have goals of consistency in performance, and in execution.
If you are looking to make a million dollars overnight, the Covered Call strategy is not for you. This strategy is a slow grinding, consistent approach to making smaller percentage returns. But as you accumulate and compound, it is a strategy that has proven to outperform the broader market (reference to leading market indices) almost each and every year.
Don’t search for high return Covered Calls as this is a low probability trade. Realistically, the Covered Call is optimal between 2.5% to 3.5% per month.
Commandment 10: Choose ITM/ATM/OTM according to broader market/economy cycles.
Knowing how to implement your Covered Call also requires an outlook of the broader stock market and economy. This strategy profits from sideways to rising markets. Hence, by being able to identify suitable market conditions will help establish a higher probability of success.
A simple method I use to evaluate broader stock market direction is to use a 50-day & 100-day moving average combination, over a leading market index such as the S&P500 or the ASX200. When this indicator identifies a bullish market, I adopt Out of The Money (OTM) positions. When the market slips in between the 50/100 combination, I enter At The Money (ATM) or In The Money (ITM) Covered Calls. And when a Bear market is identified, I don’t adopt the Covered Call strategy at all.
Matthew Brown – US Stocks & Options specialist
US Equity & Option Client Advisor
Halifax Investment Services
ASIC Australian Financial Services License Number – 225973
If you would like to learn more about the strategies you can use to profit from any type of market direction, visit www.australianinvestmenteducation.com.au or you can contact Matthew on firstname.lastname@example.org
Matthew is an Authorised Representative of Halifax Investment Services (Halifax). Halifax provides broker services, including Full Service and Discount Services using multiple trading platforms. For Discount platform services, Halifax charges the same fees for phone service as the online trading platform.