Our focus here is going to be using covered calls, but also from an investing as an alternative to a trading context – hence the name, covered call investing.
The main difference between ‘investing’ and ‘trading’ is that traders only intend 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 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.
Given 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 need to pay attention to, but covering the longer term than a trader. As a consequence coming 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 should be to observe a pattern. Once we recognize such a pattern, we then await an opportunity to purchase the stock at the lower end of it.
Our covered call investing strategy would begin with our belief that the stock is close to a strong price support area. The best support areas are the ones 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 may not be entirely necessary, but when it is available, it gives us greater confidence.
The first step in our covered call investing strategy involved selling ‘out-of-the-money’ naked PUT options with a strike price at the price level where we are prepared to purchase the stock. You will receive some income out of 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 when possible, otherwise the stock may hit your anticipated level, then rebound 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 will collect further income from this, which again, will further decrease 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 purchased, are trading in a narrow range over the longer term. You can employ this strategy to receive an additional income stream apart from dividends, since your opinion 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 try to find 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 high probability of success. Buy them at the bottom end of the narrow range and sell your call options. Keep doing this each 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 character is, that instead of risking a greater amount of investment capital by paying for 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 cost. 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 smaller amount of capital at risk. Calendar spreads can have various structures, risk profiles and outcomes but this is one of them.
Owen has traded options for many years and writes for “Options Trading Mastery” – a popular site all about option trading. Discover the advantages of covered calls and give yourself a trading edge over the markets.
