Investing Using Covered Call Options
Our focus here is going to 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 the fact that traders only intend to buy and hold for the short term with a view to quick turnover of stock and hopefully, profits.
The 'investor' on the other hand, is usually described as one who has some attachment for the stock and intends to hold for the longer term, in the hope of ultimately receiving some capital gain, plus tax effective income by means of dividends.
Now that we have now explained the difference, let's explore some covered call investing strategies 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 should pay attention to, but over 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, together with horizontal support and resistance lines, across the peaks and troughs of the weekly bars of the chart. Our aim is to observe a
pattern. Once we recognize such a pattern, then we wait for an opportunity to buy the stock at the lower end of it.
Our covered call investing strategy would commence with our belief that this stock is in the vicinity of a strong price support area. The best support areas are those that are confirmed by TWO converging trendlines - for instance, an upsloping line under the troughs that converges with a horizontal support line by looking at where the 'resistance' level has now become support, historically. This is not 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 having a strike price at the price level where we are prepared to purchase the stock. You will receive some income from this, which effectively serves to 'discount' the price you pay 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 bounce north without them being assigned to you.
Once you have the stock, your second covered call investing step, is to now sell CALL options at a strike price higher than the stock purchase price. You'll receive additional revenue from this, which again, will further reduce the effective purchase price of the shares and lower your overall risk of
retaining 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 unlikely to receive much in
the way of a gain on the shares themselves. As such, if you utilize a stock screener to search for optionable stocks with low 'historical volatility' (HV) but also with reasonable 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. Keep doing this every month or each time you see the opportunity and you are probably not going to be exercised and have your shares called away.
An alternative to a covered call investing strategy of this nature is, that in preference to risking a greater amount of capital by purchasing the shares themselves, buy 'leap options' on the stock. These are options which an expiry date of no less than 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.
The above strategy is usually called a 'calendar spread' and has been described as the "poor man's covered call investing strategy" due to the lower amount of capital at risk. Calendar spreads can have various structures, risk profiles and outcomes but this is one of them.
Investing Using Covered Call Options
By: Owen Trimball
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