Covered Call Flubs and Fixes

03/21/2012 3:30 pm EST

Focus: OPTIONS

Joe Kinahan

Chief Market Strategist, TD Ameritrade

Common mistakes and mismanagement of positions often plague covered call traders, explains Joe Kinahan, who imparts advice on how to properly execute the strategy in these or any conditions.

Covered calls are a great way to increase your profits a bit when you own the underlying, but what about in a period of low volatility like we have seen recently?

Our guest today is Joe Kinahan to talk about that. Joe, if I am not going to get a whole lot of premium because of volatility is low, is it still a good idea to do a covered call? 

Well, one of the things that people should think about is you don’t have to put all your eggs in one basket.

Let’s say you own 200 shares of a stock. You can do one contract in March and one contract in April; sell it against the stock. Then, when March is up, roll that one out to May.

One of things that you will start to see if you start to do this is that you will get an average volatility throughout the year. To say I am going to sell the absolute high end of volatility and buy the absolute low in volatility, that is a fool’s game, and in the end, you probably won’t make any trades whatsoever.

When you think about a covered call, the real goal should be to enhance your return. It is a small enhancement every month.

Many people will say to do in-the money calls, but I think you would probably want to think about doing an out-of-the-money call.

Then we talk about Delta; 35 Delta is a good area to consider, and another way to look at Delta is the probability of your stock being called away.

See related: Delta: The King of All Option Greeks

Many people, when their stock is about to be called away, they thing “Oh my God, I better cover them.” You can let the stock go; you can always re-buy it and try and re-buy it at a lower price.

So if you had a stock that was trading for $23, for example, and you sold the 25 call on it (say you received a dollar for it, just to keep all the math simple). If I said to you today that in 35 calendar days—next expiration—you would sell your $22 stock for (25+ 1) $26, you would be like, of course. Then when it is actually going to happen, why don’t you let it happen? You can always re-buy the stock.

Are there certain stocks that are better for this kind of strategy in a low-volatility environment?

Well, I know that many people like to do it in higher-volatility stocks. The only thing I can say there is the volatility is higher for a reason. There is more chance of us moving to that strike than there is in a low-volatility stock.

So if you go along the same Delta, that equalizes the volatility over time, so it puts everything into perspective as to your chances of getting the stock called away.

Obviously, you want to receive as much money as possible, but if it is really a stock you want to hold onto—you have it for family reasons, work reasons, or whatever—then you also might want to think, as I said, about going out in time and lessening the chances of getting it called away.

This adds another level to this, but what about selling a put in addition to?

That’s a great, great way to buy stock. So many retail traders want to go out and buy XYZ stock at this price. I will use my $22 stock example. They are charting the stock and go, “If it gets to $20, I am going to buy it.”  Rather than putting in that limit buy, something to think about is to sell the 20 put, because if it goes below $20, somebody is going to put the stock to you anyway and you can collect the premium.

The beautiful thing would be if you sell that 20 put many months in a row and you never put get put the stock. People will come back and say, “Well, what if we don’t go there and I miss out when the stock goes to the upside?” All I really have to say there is “boo-hoo,” because you put on a trade where you were wrong and you made money. For most retail traders, that is not really their issue!

Right, it seems traders always worry more about missing out than taking a loss.

You know, two things: They always worry about missing out, and it is always about “How much can I make?”  They don’t really think about how much they can lose.

That is really a big difference that separates professionals from people who are just kind of rolling the dice, so to speak.

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