9 Tips for New Covered-Call Writers

06/20/2013 9:30 am EST

Focus: OPTIONS

Mike Scanlin

CEO, BornToSell.com

Don't write a covered call just before earnings, says Mike Scanlin, who shares this and a number of other tips that new covered-call writers should understand.

My guest today is Mike Scanlin of BorntoSell.com, and we're talking about covered calls but specifically, which stocks in your portfolio you should be writing calls against.  So Mike; if I've got a basket of, say, 20, 30, or 40 stocks, which ones should I be selecting for covered calls?

You can write covered calls against almost any stock.  They have options available on all stocks traded these days.  The ones you want to write against are probably ones that may not have earnings coming out right away because of volatility.  Although it drives, the option premium will limit your upside with the covered call strategy.  If it is something you're bullish on, you probably don't want to cap your upside.  Other stocks you know that are low beta-that are not as volatile-you may still find it is worthwhile to write calls against, but you have to go out through your six months; the short-term one-month options probably don't have enough premium in them.

If I've got 100 shares or 1,000 shares, should I be writing covered calls to equal exactly the number of shares I have at the end of the line?

Right.  Well, there is 100:1 ratio between the option contract and the share, so if you have 100 shares, you would write one contract.  If you have less than 100 shares, you can't write a covered call.  It comes down to transaction costs.  If you have a single contract trade, you may find the transaction cost is a bigger percentage of the premium than you were happy with, so you may need 200 or 300 shares or more to make it effective.

Okay.  Then if I am writing against half of my portfolio, is there anything I could do with the other half to make money with options?  Can I sell a put or something if I want to buy more of those things?

Sure; selling a naked put is the same trade as a covered call, so you could do that.  It is a good way to acquire stock below the current price.  I would write calls against everything you have.  There is really no reason not to, considering transaction costs, of course.

All right.  How about spreads?  We get into more complicated iron condors and things like that; how about those kinds of strategies?

Those are worthwhile strategies, and people do well.  They require a little  more maintenance, because they are multi-legged spreads, and it is not as easy to modify those positions once you are into them,  because you have multiple legs, and they each have a separate bid ask spread so a little more slippage when you roll those positions to another one.  Conceptually, covered calls are very easy.  A lot of people get them.  It is a two-legged trade.  You own the stock; you short the call.  Very simple to get, and anybody can do it who owns stock.

I have noticed over the years-and especially in the last five years-the investor sophistication with calls and strategies and options, in general, has really accelerated.  What do you attribute that to?

You know; options popularity has been increasing like crazy.  The number of options traded is going up 25% a year for like the last 39 years; and now they have the weeklies trading on 160 different stocks.  I think people are just getting better educated about it.  They are tuned into the strategy.  They realize it is a low-yield environment and selling calls against their stocks, they can get more yield from things they already own.

All right; and you mentioned the weeklies.  What about using weeklies as covered calls?

It is a great strategy, because the four weeklies time premium is going to be larger than a one-month time premium; so selling the near-term option is always a way to increase; get the most time premium out of your equities.

But transaction costs, and you mentioned, may go up as well.

Definitely.

All right.  Are there certain sectors in my portfolio that are right now particularly good for covered calls?  Is it just the most volatile, whatever that might be?

Well, the call premium tracks the volatility, so the volatile ones pay better.  You know, you really shouldn't buy stock to write calls against it unless you fundamentally own the stock, so my first rule is buy stock you are happy owning anyway, even if your weren't writing calls against it; and then write calls against it to get some extra yield off of it; but I wouldn't recommend buying stocks specifically for the purpose of writing calls, just because it has attractive premiums.  You are going to get into some really risky situations, and you may not take the time to do the homework and find out why those premiums are so high.  Maybe there is an FDA announcement or an M&A rumor is circulating and if you don't have the reason why those premiums are so high.  You can wake up one morning in a bad situation.

All right; and then finally do I let them go to expiration if they are in my favor, so should I be safer; lock it in if I am close and I have made a profit here and then wait until the new cycle begins and buy them again?

Yeah; it depends on how close the stock is to the strike price.  If it is real out-of-the-money, I just let it expire worthless and save the transaction cost.  If it is in-the-money and you want to roll it, it is probably a good idea to roll it before expiration so you don't subject yourself to early exercise; but if you've got 80% to 90% of the premium out of the position you thought you were going to get, it is reasonable to close it at that time.

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