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Covered Call Writing: spotting a good candidate

by Thomas Mullooly on April 11, 2009

Probably the toughest part of covered call writing is finding the right idea.

And ideas change all the time — as markets change, prices change and the option prices (premiums) also change.

Let’s quickly review what “covered call writing” actually means.

Covered Call Writing (sometimes called “buy writes”) involves the simultaneous purchase of stock AND sale of options.  Remember, any time you sell something, you are bringing money into your account.  So you are BUYING a stock (you are spending money) and also SELLING something at the same time (bringing money in).

If you were to buy 500 shares of XYZ at $50, you would SPEND $25,000.  If you were to buy 500 shares of XYZ and also sell 5 calls with a strike price of $55 (sold at a price of $9), you would only SPEND $20,500.  Put another way, your “net” cost would be $41 (buy the stock at $50, sell the calls for $9).

With me so far? 

Great.  Onward.

Now, whenever we examine any stock, there are three possible outcomes:

  • Stock moves up
  • Stock does nothing
  • Stock goes down

In only one of those scenarios will you make money if you simply buy the stock.  Right?

Now what we have done in this example is this:

  • We lowered our out-of-pocket cost to buy the stock from $50 to $41.
  • We have protected our “downside.”  Yes, the stock trades around $50.  But we are at break-even – even if the stock falls to $41. And the charts will clearly define where we should have a stop order to protect us.
  • Yes, we have limited “upside” — the stock could be taken away from us at $55, but we were paid $9 for that chance. (By the way, if that happens, what is the gain?  Bought at $50, called away (sold) at $55 for a 10% gain, plus you were paid $9 as well.  Sweet.)

When looking for candidates for call writing, here are a few things I try to keep in mind:

Covered call writing works well when the market is confused.  Like now. We have short periods of time where the market runs straight up, and then reverses quickly.  In the big picture, we are still in a negative trend for most major indices, but getting closer and closer to testing resistance lines.  We still do not have confirmation this is a significant turning point, and no clear signals the market is turned a page.

So covered call writing is also an excellent way to get some money into the market, and still protect your downside exposure, or simply just bring in additional money into the account.  It’s a great way to goose the yield on your money as well.

But the main thing to know is that you need individual stocks that are in uptrends.  A few weeks ago, there were only a small handful of stocks in uptrends.  Now there are more.  Here are some stocks that are in uptrends that may make good covered call writing candidates.  These are *NOT* recommendations. Call me and we can walk through what makes sense for your own individual situation.

Again, I am not recommending writing calls for everyone on the following:

IBM, Amazon, Reliance Steel, Imperial Oil, Scotts (Miracle Gro), Apple, EMC, Borg-Warner, AutoNation, Staples, and many more.

We need option papers on file.  And we need to have a thorough discussion so you understand clearly how this works.  I would not write about this if I did not feel comfortable at least discussing the topic with you.

It’s worth a look, don’t you think?

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