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Covered Call Writing Strategies

OK, so now we've looked at the first covered call writing strategy using acovered call writing by Anna covered call approach which was called the buy write, where the whole trade was constructed simultaneously, and based on a speculative approach to the trade. Now the second approach is more of an investment based strategy, and is called the over write, so let's look at this in learning about covered call writing strategies.

Covered Call Strategy

This covered call strategy is used where you have an existing portfolio of stocks and shares, and which allows you to generate additional income from your portfolio in order to lift your overall returns. Now I have to say straight away, that I always encounter resistance from investors when discussing this strategy with them for two reasons as follows :

  1. They are in love with their stocks
  2. They are not prepared to write calls which give up 'possible future profits'

If you remember, right at the start of this site, I did say that in order to use this strategy successfully you must not be wedded to your stocks or shares. In the buy write this is generally not a problem, however, in the over write it often is! Portfolio's have been built up 'lovingly' and with care, and generally with a more fundamental approach rather than a technical approach ( see  trader types at Making Bread ). Investors will often go to annual meetings, will know everything about the company, it's management and its markets! In short, they do not look at trading as a business for making money, they see it as an investment for the longer term. There is nothing wrong with this approach - it is perfectly valid. However, it is a little like owning a row of houses, and not renting them out in order to increase the yield, but simply waiting for capital growth in the underlying asset - in this case the house.  Writing calls on a portfolio is a little like renting out your stocks or shares, where you are looking to increase the yield - why not?

OK, let's assume you are open minded, and view trading as a business rather than a long terms investment. How is this strategy implemented - again it is very simple and mechanically the same as before. The difference in this case is that you already own the underlying asset, the stock, and I am going to assume you have a stop loss in place - if not you should put them in NOW. From here onwards the approach differs in subtle ways.

Covered Call Writing Strategies

In selecting your stock you may decide to take the same approach as in the buy write strategy, so you could look for stocks in your portfolio which are neutral to mildly bullish and trending sideways in a nice channel, neither going up or down, just sideways. Now assuming the stock has options available we could write one for the following month, with a strike price just above the market price as before. This is one approach.

A second approach could be that we have decided to sell the stock anyway, and therefore are not particularly interested in writing several calls, one after the other, but as we have decided to sell anyway, we might as well try to make some additional income before we do - if exercised - good because we were selling anyway, if not, we have lost nothing and gained some income, and we can simply sell  the stock anyway ( we might realise that this is quite a useful strategy and write another one of course!! )

A third approach might be that again we have decided to sell a stock, but not for a few months. We could choose a longer term call option, with a higher premium and write this 3 month call option say, or even a 6 month call option. Whilst time is no longer on our side, and we would probably be exercised, if we have decided to sell in a few months anyway, why not make some extra income in the meantime. Now of course, remember we are always forfeiting 'possible' future profits by writing the call. The reason I say 'possible' is because again this is always an issue with investors. With the covered call strategy, they will always argue that they are giving up future profits by writing the call. My argument is always the same and is this - these profits are only possible, there is no guarantee that you will close out your long stock position in the future at a profit anyway. The chances are you would not, simply because everyone is greedy, and you would hold out for higher profits still, probably as you watch your stock falling again! So my argument is this - by writing the covered call, you are guaranteeing the profit if the stock rises. Without the call in place, there is no guarantee you would close out the stock at a profit.

Finally on the strategies available for the over write, you could even look at LEAPS!!! Just as an example I had a quick look at the MCD options chain for LEAPS - for a Jan 10 Call Option with a strike of $60 you would receive a premium of $530, which coupled with a possible profit on the stock would give you $1080 in total - tempting? - possibly, but remember time is not on your side, this is three years away and a lot can happen in three years. If the stock rocketed to $80, it no longer looks such a good deal!!!!!!

Now, one final point. As the over write is used for writing calls on existing stocks or shares in a portfolio, you may have several hundred or several thousand of the stocks available. Now supposing you had 1000 stocks of MCD, you could decide to only write calls on half the holding, so you would sell 5 calls, you may decide to sell 10 ( the whole holding ), or just one or two. It all depends on your strategy for the underlying stock, but each approach is fine. And remember, you can only write a call on a whole number holding ( 100 in the US and 1000 in the UK ) so if you hold 250, you cannot write a half contract! - you could only write 2 contracts, but then you could decide to buy another 50 to make up a full block of 100 to write another one. You see how flexible covered calls writing really is!!!

 

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