Covered calls are considered universally safe. They create profits from option premium, capital gains and dividends. Some traders believe the covered call is so safe that it can be opened at any time. This is flawed thinking.
If the stock price falls below your net basis, you have a paper loss. (Net basis is the cost of stock, discounted by the premium you receive for selling the call.) You then have to wait for the stock price to recover before taking any further action. Five steps help offset this market risk.
- Check the fundamentals. As a starting point, select strong fundamental companies for any form of options trading. Start with dividend per share (preferably with increases every year for the past 10 years); dividend payout ratio (steady or rising); and the dividend yield (preferably 4 to 6 percent); P/E annual range (preferably between 10 and 25); revenue and earnings (both should be on the rise, with net return remaining consistent); and the debt capitalization ratio (look for a steady or declining ratio and avoid companies whose debt ratio is on the rise).
- Track the chart’s stock looking for short-term low price. Once you develop your short list of four or five companies meeting your fundamental criteria. Within long-term trends, you will notice shorter-term opposite trends and retracements. Time the purchase of shares for a bottom in the stock price. You can find the bottom by seeking strong reversal signals in candlesticks, volume and momentum.
- Next, track the stock chart looking for price peaks. Once you buy shares, wait for the price to rebound. Then find a price peak to time the selling of a covered calls. Look for bearish reversal candlestick signals that are also confirmed by volume and momentum.
- Open the covered call with the best possible strike and expiration. Picking the best strike and expiration is critically important. The best strike is slightly out of the money. For example, the stock is trading at $48.50 per share. Sell a covered call at a strike of 50 (assuming you paid less for your stock). This provides a capital gain if the short call is exercised, and also maximizes your profit potential. Pick expiration within two to four weeks. During this period, time decay is rapid. Selling calls further out ties up your position longer, but yields a smaller annualized return.
- Set profit and bail-out goals. Once you have opened your covered call, set a goal for yourself to identify when you will buy to close. As long as the position remains out of the money, it will expire worthless. But you need to know when you will close based on both profit goal and loss reduction. For example, if you sell a call for 4 ($400), you might decide you will close and take profits when it declines to 2 ($200). By buying to close at that point, you take a 50% gain. You may also decide to buy to close if the value of the call rises to 5, meaning taking a 20% loss before it gets higher or before it is exercised. You can also roll forward to avoid exercise, but setting these goals also makes sense. Finally, in setting up an expiration date, avoid the period immediately before ex-dividend date. If your short call is in the money during this period, it could be exercised early by someone with a long position wanting to time their purchase to get the quarterly dividend.
The covered call is an effective and conservative options strategy. But by following these guidelines, you improve the chances for succeeding in this strategy.
The covered call may also lead to other highly conservative expansions of the basic strategy. These include variable ratio writes, covered straddles, short strangles (with the call side covered), synthetic long stock (with the call side covered), call spreads, and the uncovered put (which has the same market risk as the covered call).
There is such great potential in developing a conservative plan for options trades. With ownership of value investments in your equity portfolio, you can apply safe options strategies to hedge market risks while generating profits at the same time.