Covered Call Writing

 

 

High Yield Cover Calls Equal High Yields and High Volatility

High yield covered calls can turn a handsome profit for an investor who know what they are doing. Due to the current market volatility, call option premiums are very high. It's not uncommon these days to easily get 5%+ on certain options. However, just because the call premium is fat and juicy IS NOT the reason to sell a covered call. 

 

It is important to remember that any investment in a stock has three potential directions. The first is to move up, the second is to plateau or stay the same, and the third is to decline. That leaves three possibilities, each with greatly varying influences on your ability to profit. When you add the covered call option to your stock, you can help guide the outcome in your favor, regardless of what it may be. 

How is this possible? When you opt to offer the right to buy your stock at a later date for a set price, you can guarantee some return on the investment. Naturally, if the stock does well and goes up, you will get the agreed upon price as well as the premium paid for the covered call option. If the stock really runs up, you may be leaving some money on the table though unless you choose to buy back the calls at a higher price. If the stock goes down or does not move at all, at expiration you probably will still hold on to the stock as well as the entire premium paid for the covered call option. If the stock declines, you have some built-in insurance, i.e., subtract the call premium from the stock price and that is your basis. For example if I bought Green Mountain Coffee (GMCR) at $85 and sold the front month call for $2.50, GMCR could go to $82.50 before I would lose money. 

Gauging Risk When Investing 

Stock market investing is all about risk, and gauging your risk is vital to success. As a buyer, you may be working with a more volatile stock, which will mean the highest yielding covered calls may be very risky. As the seller, you could be selling off potential profit after the covered call sale is complete if the stock dramatically rises or take a bath if the stock tanks. It's critical to understand the trend of the stock because it is related to the covered call yield, the sector it's in and the broad market to know if an in-the-money call, out-of-the-money call or at-the-money call is the best strategy for the current period. These things must be taken into consideration to ensure that you make a sound decision. Compound stock earnings take all of these factors into account.

Don't Predict: Have a Plan for All Outcomes 

Unfortunately, there is simply no way to know what the stock market will do. As traders, we need to trade what we see, not what we believe. On any given month when I roll over calls, I spend time looking at the daily and weekly charts to understand if the underlying stock is rising to a supply level (resistance) or falling to a demand level (support). If I see it in a major supply area and the market looks the same, I will most likely write a near-the-money call. If the market really looks overbought and ready to pull back, then maybe a deeper-in-the money call to take advantage of the pull back. If I am wrong, then I get out, close the position and sell a new call in the trend direction, or wait it out. There have been times when a stock like BIDU breaks out and runs up $10 or more. During those times, I buy back my call as soon as possible and let the stock run.

On a down turn, it's the same; dump the stock and close out the call for a profit. I use long-dated puts as insurance on all the positions, so in this case, I unload the stock, bank the call premium and let the put work for me until the stock reaches a demand level and it's okay to buy again. Have a plan and the profits will be yours!

 

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