Successful covered call writing requires solid technical analysis and market assessment skills, explains Alan Ellman.
Stock and option selection are two of the three-required skills essential to successful covered call writing; position management is the third. There is not one factor that will dictate our choices but rather a mosaic of information, which will lead us to the best choices.
Here, we discuss two of those critical parameters: technical analysis of the underlying security and overall market assessment. Let’s start with viewing the chart of an elite performer on our Premium Watch List from March 20, 2020, Quidel Corp. (QDEL).
QDEL price chart
QDEL: Bullish Chart Pattern
At this point, we have an elite performer both fundamentally and technically and one would be leaning to selling one of the bullish out-of-the-money strikes. However, let’s have a look at the chart of the S&P 500 and CBOE Volatility Index (VIX) to assist us evaluate our overall market assessment:
Comparison chart of VIX and S&P 500
S&P 500-VIX Comparison Chart 3/23/2020
Note that in the past three months, the market volatility has increased exponentially (428%) while the value of the S&P 500 has declined precipitously, 31%. This was directly a product of the Coronavirus crisis impacting the global economy. For many investors, this red flag guides us from bullish out-of-the-money strikes to the more conservative in-the-money strikes giving us a bit of a cushion when it comes to capital preservation. Next, let’s view the options chain for QDEL at the time I produced the above screenshots:
QDEL 1-month option-chain (www.cboe.com)
QDEL Option-Chain March 23, 2020
With QDEL trading at $88.75, we will evaluate the in-the-money $80.00 strike feeding the stats into the multiple tab of the Ellman Calculator:
QDEL calculations with the Ellman Calculator
QDEL Calculations with the Multiple Tab of the Ellman Calculator
The in-the-money $80 strike creates an initial time-value return of 5.3%. It also yields 9.9% downside protection of that time value initial profit. This means that we are guaranteed a 5.3%, one-month return as long as our shares do not depreciate by more than 9.9% by expiration. I call this downside protection (very different from break-even) an insurance policy that is paid for by the option buyer, not by us.
Discussion
Many factors are considered when selecting underlying securities and strike prices for covered call writing. Taking the most bullish positions (out-of-the-money strikes) are most appropriate when both chart technicals and market assessment are bullish. If either component is compromised, selling in-the-money strikes will afford us downside protection and provide a cushion for capital preservation.
Use the multiple tab of the Ellman Calculator to calculate initial option returns (ROO), upside potential (for out-of-the-money strikes) and downside protection (for in-the-money strikes). The breakeven price point is also calculated. For more information on the PCP strategy and put-selling trade management click here and here. I'll be presenting a free, one-hour webinar for the Options Industry Council on Wednesday May 8 at 3:30 p.m. CST, entitled, Covered Call Writing: Basics and Practical Application. The event is open to all. Just follow the link above to register.
Even if you feel you may not be able to attend the live presentation, sign up and receive a recording to review at your leisure.
