Covered Call Investing
Our focus here will be using covered calls, but in an investing rather than a short term trading context
. Hence the name, covered call investing.
The main difference between 'investing' and 'trading' is that traders only plan to buy and hold for the short term having a view to quick turnover of stock and hopefully, profits.
The 'investor' on the other hand, is usually identified as anyone that has some attachment to the stock and plans to hold for the longer term, in the hope of ultimately receiving some capital gain, plus tax effective income by means of dividends.
Given that we have now explained the primary difference, let's explore some covered call investing methods for the longer term investor. The market price of stocks is continually in a dynamic state of rise and fall and that is that which we need to be aware of, but covering the longer term than a trader. As a consequence from a technical analysis perspective, we'd be more interested in consulting "weekly" stock charts than "daily" ones. We would draw trendlines, combined with horizontal support and resistance lines, along the highs and lows of the weekly bars of the chart. Our aim is to observe a pattern. Once we recognize such a pattern, we then wait for an opportunity to purchase the stock at the lower end of it.
Our covered call investing strategy would commence with our belief that the stock is in the vicinity of a strong price support area. The best support areas are the ones which are confirmed by TWO converging trendlines - for example, an upsloping line along the troughs that converges with a horizontal support line based on where the 'resistance' level has now become support, historically. This may not be entirely necessary, but when it is available, it provides for us greater confidence.
The initial step in our covered call investing strategy involved selling 'out-of-the-money' naked PUT options with a strike price at the price level at which we are prepared to purchase the stock. You will receive some income out of this, which effectively serves to 'discount' the cost to you for the stock when exercised. The idea is to exercised on the options, so do this with about a maximum 2 week to option expiry timeframe if possible, otherwise the stock may hit your anticipated level, then rebound north without them being assigned to you.
After you have the stock, your second covered call investing step, is to now sell CALL options at a strike price above the stock purchase price. You'll collect further revenue from this, which again, will further decrease the effective purchase price of the shares and lower your overall risk of holding them.
The best conditions for covered call investing are when the stocks you either own, or have just acquired, are trading in a narrow range over the longer term. You can employ this strategy to receive an extra income stream other than dividends, since your belief is that you're not likely to receive much in the way of a gain on the shares themselves. As such, if you utilize a stock screener to try to find optionable stocks with low 'historical volatility' (HV) but also with acceptable liquidity (at least 500,000 shares traded daily) then your covered call investing has a great chance of success. Buy them at the bottom end of the narrow range and sell your call options. Continue doing this every month or each time you see the opportunity and you are unlikely to be exercised and have your shares called away.
An alternative to a covered call investing strategy of this character is, that in preference to risking a greater amount of capital by paying for the shares themselves, buy 'leap options' on the stock. These are options which an expiry date of at least one year out. The effect is like owning the shares for a year but for a fraction of the price. Sell short term expiry call options above the strike price of the 'leaps' and receive a monthly income.
This strategy is usually called a 'calendar spread' and has been described as the "poor man's covered call investing strategy" due to the smaller amount of capital at risk. Calendar spreads can have different structures, risk profiles and outcomes but this is one of them.
by: Owen Trimball
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