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tjlocke99

Covered Calls and Synthetic Covered Calls

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Good morning.

Does anyone have some resources they could recommend on covered calls and synthetic covered calls?

Examples of questions I have are:

1. Is it better to sell slightly OTM calls or ATM calls?

2. Better to sell weeklies or monthlies and how far should/could the expiry be?

3. What to do around the ex-dividend date and earnings time?

Thank you!

Richard

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Good morning.

Does anyone have some resources they could recommend on covered calls and synthetic covered calls?

Examples of questions I have are:

1. Is it better to sell slightly OTM calls or ATM calls?

2. Better to sell weeklies or monthlies and how far should/could the expiry be?

3. What to do around the ex-dividend date and earnings time?

Thank you!

Richard

I'm definitely not an expert (I can count the number of years I've been playing at stocks on my hands, and options on one hand), but here is my opinion since I started options by selling covered calls and still do that in my retirement account.

1) It depends on 2 things: the premium and the stock. Solid, low beta companies typically have low premiums because they don't move as much. At this point, selling OTM calls will only gain you a few percent if you are lucky. When I sell covered calls, I usually like to do it for a month or two max (to capitalize on the best theta). If we look at a stock like KO, the NOV 38.75 call is selling for .81 (around 12-13% annualized). The 40 call is selling for .32 (about 5% annualized). So here, you pretty much have to sell the ATM call to make what my bare min for return is (I usually shoot for 12%+). The other thing that comes into play is where you think the stock is going. Right now, I think KO is overvalued a little, but not by much. I could see it coming back to $37-37.5 in the near future, but it isn't likely. So I may sell the $37.5 call for 1.59. If I'm right, this protects my position down to $36.82, if I'm wrong, I make .60 or 9-10% annualized. In this case, the premium isn't worth it, so if I was going to sell a covered, I'd sell the 38.75. The OCT options don't look appealing to me. Right now, I have no short positions against my KO long position. More volatile stocks work better for covereds.

2) Depends on your risk tolerance. I never go more than 3 months out when selling. I rarely hold until expiration. Usually sell with a week or so left unless I really like where it is at. I'd probably not sell weeklies, but that is more because I do covereds in an account where I don't do a lot of tinkering on a daily basis.

3) I typically try to avoid earnings on my covered calls that I am specifically writing for premium. If it is part of my core holdings, I will hold the options through (because as we've learned here, earnings are hard to predict, so don't try). For ex-div. If I am writing the covered specifically for the premium (meaning I want it to get called away), I'll hold through ex div and hope it gets called away. If it is part of my core holdings and I am not looking to trim, I'll buy it back before ex div if it is deep ITM. If it is ATM, I may buy back if the premium is close to the div amount. If I am looking to trim, I'll let it go.

Really, there are no hard and fast answers. Depending on your stocks, your own personal levels of risk tolerance, and the current state of your portfolio, the answers to all 3 of those can vary.

I think Chris currently sells weeklies against a long AAPL call, but as he mentioned in a post, you know to know how to adjust and what to do. If the stock blows through the bottom of your protection, do you sell the next week's option at the lower rate and eat it? Do you hold hoping it comes back? etc. Monthly options are just safer for me, plus you get more downside protection, which I like for my purposes.

Edited by trhanson

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I'm definitely not an expert (I can count the number of years I've been playing at stocks on my hands, and options on one hand), but here is my opinion since I started options by selling covered calls and still do that in my retirement account.

1) It depends on 2 things: the premium and the stock. Solid, low beta companies typically have low premiums because they don't move as much. At this point, selling OTM calls will only gain you a few percent if you are lucky. When I sell covered calls, I usually like to do it for a month or two max (to capitalize on the best theta). If we look at a stock like KO, the NOV 38.75 call is selling for .81 (around 12-13% annualized). The 40 call is selling for .32 (about 5% annualized). So here, you pretty much have to sell the ATM call to make what my bare min for return is (I usually shoot for 12%+). The other thing that comes into play is where you think the stock is going. Right now, I think KO is overvalued a little, but not by much. I could see it coming back to $37-37.5 in the near future, but it isn't likely. So I may sell the $37.5 call for 1.59. If I'm right, this protects my position down to $36.82, if I'm wrong, I make .60 or 9-10% annualized. In this case, the premium isn't worth it, so if I was going to sell a covered, I'd sell the 38.75. The OCT options don't look appealing to me. Right now, I have no short positions against my KO long position. More volatile stocks work better for covereds.

2) Depends on your risk tolerance. I never go more than 3 months out when selling. I rarely hold until expiration. Usually sell with a week or so left unless I really like where it is at. I'd probably not sell weeklies, but that is more because I do covereds in an account where I don't do a lot of tinkering on a daily basis.

3) I typically try to avoid earnings on my covered calls that I am specifically writing for premium. If it is part of my core holdings, I will hold the options through (because as we've learned here, earnings are hard to predict, so don't try). For ex-div. If I am writing the covered specifically for the premium (meaning I want it to get called away), I'll hold through ex div and hope it gets called away. If it is part of my core holdings and I am not looking to trim, I'll buy it back before ex div if it is deep ITM. If it is ATM, I may buy back if the premium is close to the div amount. If I am looking to trim, I'll let it go.

Really, there are no hard and fast answers. Depending on your stocks, your own personal levels of risk tolerance, and the current state of your portfolio, the answers to all 3 of those can vary.

I think Chris currently sells weeklies against a long AAPL call, but as he mentioned in a post, you know to know how to adjust and what to do. If the stock blows through the bottom of your protection, do you sell the next week's option at the lower rate and eat it? Do you hold hoping it comes back? etc. Monthly options are just safer for me, plus you get more downside protection, which I like for my purposes.

Thank you trhanson for this informative post. One question:

try). For ex-div. If I am writing the covered specifically for the premium (meaning I want it to get called away), I'll hold through ex div and hope it gets called away. If it is part of my core holdings and I am not looking to trim, I'll buy it back

I am not sure what you mean here? Why would you want the stock to get called away? If you have an example then I think that would help me. Thank you again for your time!

Richard

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Thank you trhanson for this informative post. One question:

I am not sure what you mean here? Why would you want the stock to get called away? If you have an example then I think that would help me. Thank you again for your time!

Richard

Sometimes, the premium on the covered call is quite good. I may not have any interest in holding onto the stock long term, so I may do a buy write. I'm going to give you a for instance using a real stock, but PLEASE do not buy this stock without doing research on it. I think energy prices are going to be stable or increasing the next month, so if I'm looking to capitalize on this in the short term, I may look for a stock that has been been putting a good floor, and is not going to collapse for the short term. A good example is FXEN. It has traded in a pretty tight range and is currently in the bottom where it has some support. I have no interest in owning it long term (it really doesn't do too much for me), BUT the October 7.5 call is selling for .90. Thats 13.7% if flat with 3 weeks left! Depending on your annual calculation method, that is between 237-265% annualized return. Since they don't report (and have no div), it would be a full holder. My goal here is to have my stock called away here, take my 13.7% and run.

*Note: I am considering this trade.

Edited to add: I don't think that the stock will move to be 8.4 in 3 weeks, which also makes it a good covered call IMO.

Edited by trhanson

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Sometimes, the premium on the covered call is quite good. I may not have any interest in holding onto the stock long term, so I may do a buy write. I'm going to give you a for instance using a real stock, but PLEASE do not buy this stock without doing research on it. I think energy prices are going to be stable or increasing the next month, so if I'm looking to capitalize on this in the short term, I may look for a stock that has been been putting a good floor, and is not going to collapse for the short term. A good example is FXEN. It has traded in a pretty tight range and is currently in the bottom where it has some support. I have no interest in owning it long term (it really doesn't do too much for me), BUT the October 7.5 call is selling for .90. Thats 13.7% if flat with 3 weeks left! Depending on your annual calculation method, that is between 237-265% annualized return. Since they don't report (and have no div), it would be a full holder. My goal here is to have my stock called away here, take my 13.7% and run.

*Note: I am considering this trade.

Edited to add: I don't think that the stock will move to be 8.4 in 3 weeks, which also makes it a good covered call IMO.

Fantastic example Tyler! Thank you.

How do you typically find candidate trades like this?

R

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Synthetic covered calls are useful for stocks that have high prices (like AAPL) since you don't have to have so much capital to buy 100 shares, but I think the concepts are the same. Your losses are indeed capped, but you have to buy them deep ITM to get a delta of close to 1, and if the stock falls, you are then padded some by the time premium left, so it could be a good play. I think Chris does it. I don't typically work with stocks in those price ranges. It's psychological, I know, but

As for screening for calls, I'll give you an example of a couple of methods that I use when I get home. One is really easy, and I'm kind of embarrassed to give it up, but I'll let the suspense build until I can get my other method on paper for you as well. Most of the time though, I sell calls against core positions that I intend to hold onto once they become slightly overvalued.

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Synthetic covered calls are useful for stocks that have high prices (like AAPL) since you don't have to have so much capital to buy 100 shares, but I think the concepts are the same. Your losses are indeed capped, but you have to buy them deep ITM to get a delta of close to 1, and if the stock falls, you are then padded some by the time premium left, so it could be a good play. I think Chris does it. I don't typically work with stocks in those price ranges. It's psychological, I know, but

As for screening for calls, I'll give you an example of a couple of methods that I use when I get home. One is really easy, and I'm kind of embarrassed to give it up, but I'll let the suspense build until I can get my other method on paper for you as well. Most of the time though, I sell calls against core positions that I intend to hold onto once they become slightly overvalued.

Currently the only covered call I am doing is on Microsoft (MSFT) for obvious reasons.

What do you think about covered calls on precious metals like SLV or GLD. Even Silver Wheaton? Commodities?

When you get a chance please do send me your filtering method.

Thanks again!

Richard

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As one of the other posters noted, I do sell covered calls on LEAPS -- particularly AAPL. That said, someone said they like that strategy because it "limits losses." I would respectfully disagree, as the losses, if any, are amplified over a covered call on a stock. Let's take one I'm in right now.

I bought the Dec 600 AAPL Leap when AAPL was at 690, it cost me $91.50. That week I sold the weekly 700 call for $5.50. That's a six percent return in ONE WEEK. If the price goes way up (lets say 710), sure I have to buy the call back for a $10.00 loss, but the LEAP has gained $20 -- so even a better situation.

But what if (as actually happened), AAPL drops to 660?. Well my LEAP is now worth $60.00 -- a 30% loss on your principal, in exchange for a 6% gain on the sale. Whereas if you had actually owned AAPL,, the decline from 690 to 660 is only a 4.3% loss. There's a big difference between a 4 percent and a thirty percent loss. The trade off is you still only got the $5.50, which is less than a one percent return.

So what to do when the price plummets like that and your LEAP loses value? (technically not a LEAP because it's December). This is where trade management comes in.

I'm still positive on AAPL, so I don't panic. What I do is roll short 700 call to a short 690 call (still above my original purchase price) for another $4.00. My "basis" is now $82, so my breakeven price for AAPL is 682. So in week two, I'll sell a call above that price, ideally 685-690 (which is what I did), garnering another $4.00. I continue to do so for as long as you want.

WARNINGS: Earnings can play havoc with this as you will get a large price swing. In the perfect world you do this up to one week before earnings, with AAPL's price being steady.

You also need to have a plan on what to do if the price REALLY drops out quickly (personally my plan is to avoid stocks where I see a big risk of a 10% decline in the underlying in the short term). Always have your pain point known in advance to know when to just take your losses and exit.

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Chris- with this type of synthetic covered call trade and if you are very comfortable with the 600 price point does it not give you a fair amount of space to keep rolling the weeklies over as long as the shorts are always above your 600 strike? Or is there a point in the trade where rolling does not make mathematical sense any more and should just close out the trade? I guess I am interested at what price points in the trade would you close out the trade?

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That answer changes around earnings periods -- as well as how long I've been rolling (though this is a BAD way to analyze a trade as each trade should be looked at independently).

Earnings aside, one helpful way is to try to figure out how much premium you "think" you can extract. Let's say you were to enter this trade last Thursday (though I did three weeks ago).

I like to enter these trades on Thursday's because it gives me the most premium possible on the monthly. Last Thursday the 600 call would have cost $93, and AAPL was at 681. The 690 weekly call would have gotten you $5.00 (which is what I target on AAPL, sometimes you can't get that).

Next look at how many weeks could you roll this -- 85 days to expiration, 12 weeks, but have to sell the week before, so 11 weeks. If things go as planned, and AAPL stays at around 680 (or goes up), you could theoretically earn around $55 in premium. That's a best case though, and I would plan for something less than that -- around the $45. That would work out to a 48% profit (or more if AAPL slowly rises) in a good case. That rarely happens.

But, with proper management, even when AAPL is declining, we still can get the $45 in premium. So what's our "pain" point? I personally try to target a 15% loss -- but what is that. For a rough calculation:

$93 purchase price -- break even 693 on expiration

$45 in gain (93-45) = 48.

Fifteen percent loss: 48*.85 = 40.8.

So when the value of my call option drops around 40, I'll begin looking at exiting.

Please note though that this is a dynamic calculation that assumes you're near expiration and have already collected premium. If the value of the option drops to 40 early on, I'll have collected less premium, thus increasing my losses.

For instance, in the past three weeks I've collected $16 in premium. My 15% loss point is at 65.

I personally calculate based off end losses to give me some leeway -- but I have a higher risk tolerance and know that means, while closing on a bad move in December might be a 15% loss, if I had to close earlier, it might be closer to 30%.

You need to find out what size losses you're comfortable with immediately and in the long term and position size and manage from there. Don't calculate exit points based off of potential gains in risk management (still do that, but not for risk management).

Hope that's not too rambly.

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WARNINGS: Earnings can play havoc with this as you will get a large price swing. In the perfect world you do this up to one week before earnings, with AAPL's price being steady.

You also need to have a plan on what to do if the price REALLY drops out quickly (personally my plan is to avoid stocks where I see a big risk of a 10% decline in the underlying in the short term). Always have your pain point known in advance to know when to just take your losses and exit.

Thank you Chris! Earnings and dividends both wreak havoc right? What do you do around dividend time?

Is there ever a safe stock that won't decline 10% that you sell a reasonably priced call on? I think it is really tough to figure those out :) Walmart? However their calls don't pay well.

Other than proper position sizing, what are some options when the stock takes a nosedive like you mention? Maybe purchase a deep OTM put or vertical to start with?

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That answer changes around earnings periods -- as well as how long I've been rolling (though this is a BAD way to analyze a trade as each trade should be looked at independently).

Earnings aside, one helpful way is to try to figure out how much premium you "think" you can extract. Let's say you were to enter this trade last Thursday (though I did three weeks ago).

I like to enter these trades on Thursday's because it gives me the most premium possible on the monthly. Last Thursday the 600 call would have cost $93, and AAPL was at 681. The 690 weekly call would have gotten you $5.00 (which is what I target on AAPL, sometimes you can't get that).

Next look at how many weeks could you roll this -- 85 days to expiration, 12 weeks, but have to sell the week before, so 11 weeks. If things go as planned, and AAPL stays at around 680 (or goes up), you could theoretically earn around $55 in premium. That's a best case though, and I would plan for something less than that -- around the $45. That would work out to a 48% profit (or more if AAPL slowly rises) in a good case. That rarely happens.

But, with proper management, even when AAPL is declining, we still can get the $45 in premium. So what's our "pain" point? I personally try to target a 15% loss -- but what is that. For a rough calculation:

$93 purchase price -- break even 693 on expiration

$45 in gain (93-45) = 48.

Fifteen percent loss: 48*.85 = 40.8.

So when the value of my call option drops around 40, I'll begin looking at exiting.

Please note though that this is a dynamic calculation that assumes you're near expiration and have already collected premium. If the value of the option drops to 40 early on, I'll have collected less premium, thus increasing my losses.

For instance, in the past three weeks I've collected $16 in premium. My 15% loss point is at 65.

I personally calculate based off end losses to give me some leeway -- but I have a higher risk tolerance and know that means, while closing on a bad move in December might be a 15% loss, if I had to close earlier, it might be closer to 30%.

You need to find out what size losses you're comfortable with immediately and in the long term and position size and manage from there. Don't calculate exit points based off of potential gains in risk management (still do that, but not for risk management).

Hope that's not too rambly.

Chris,

Thank you for the information you shared.

I don't get how you can calc for a 15% loss? If after week #1 AAPL drops $30 then what would you do? Would you roll the weekly mid-week? Would you exit once it drops the first $20? When would you consider re-entering, if at all?

Thanks.

Richard

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Purchasing a Deep OTM put can be helpful. I've been looking at that with AAPL -- eying ones that cost me between one to two weeks of premium. That would give a nice partial hedge (haven't finished the math though).

As far as "safe" stocks -- as you noted the premium on the "safe" stocks (MSFT, XOM, JNJ, etc) are not NEAR as high and don't normally justify the risk. I used to use MCD and IBM -- and then they both took a huge hit and just wiped out six months of premium gains. If you own the stock, not always a big deal as those can make up core portfolio holdings. If you own a LEAP or shorter term option though, you might not be able to hold for the long term.

I tend to TRY to make sure I'm getting at least a 5% return per week on the short sale/call price. That's my opinion though.

As far as dividends go, they tend not to make a big impact on the instruments I trade. I try to sell OTM calls and the DITM LEAPS aren't impacted, other than by the post ex-div standard moves.

Earnings can wreak havoc -- go look at NFLX. Anything that is at risk of a big drop can destroy you.

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Purchasing a Deep OTM put can be helpful. I've been looking at that with AAPL -- eying ones that cost me between one to two weeks of premium. That would give a nice partial hedge (haven't finished the math though).

As far as "safe" stocks -- as you noted the premium on the "safe" stocks (MSFT, XOM, JNJ, etc) are not NEAR as high and don't normally justify the risk. I used to use MCD and IBM -- and then they both took a huge hit and just wiped out six months of premium gains. If you own the stock, not always a big deal as those can make up core portfolio holdings. If you own a LEAP or shorter term option though, you might not be able to hold for the long term.

I tend to TRY to make sure I'm getting at least a 5% return per week on the short sale/call price. That's my opinion though.

As far as dividends go, they tend not to make a big impact on the instruments I trade. I try to sell OTM calls and the DITM LEAPS aren't impacted, other than by the post ex-div standard moves.

Earnings can wreak havoc -- go look at NFLX. Anything that is at risk of a big drop can destroy you.

Hmmm. There is no free lunch right :)

Another alternative would just do a deep ITM call but not a 90+ delta. Maybe something more in the high 70 or low 80 delta range.

Actually I like MSFT. Look at the returns. The commisions may kill it but the returns are not that different than AAPL if you are getting $5 a short call contract.

A few more questions/comments:

1. You won't realize that $5 profit right because you roll it each Thurs. Aren't you only realizing like $3 to $4 of that short profit?

2. What is your plan if you do get a big first week drop? In this example let's say AAPL drops $40 in one week. Not that crazy with how its going lately.

3. Did you say you would ever roll the weekly short mid week to a lower strike?

Thanks.

Richard

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Again, depends on the drop, the corresponding drop in the price, and how much premium I can get. I have done any and all.

For instance, on AAPL, last week when it dropped from 680-660, I did just roll middle week and grabbed another $3.00 in premium.

As I had only on a half position, today I actually averaged down when AAPL hit 652, I doubled up my position for $68.00. So one at $91.50, and a second at $68.00. That averages out to 79.75. With the premium I've already gained, I'm actually quite happy with the position. My current "panic" point, which will last to Thursday (when I roll) is around 630.

At 630, I would project the value of my call to be around $48-$50. I've already collected just north of $15.00 in premium (after accounting for the averaging down). That's $65.00. So at 630, if I exited, I would be facing about a 22% loss. And remember, earlier in the option, I'm more risk tolerant as the price can rebound, later on, less so.

So, what do I do when things go south?

1. Look at averaging down

2. Look at rolling the short down for more premium

3. Look to exit

And, I can hold some losers longer, depending on the overall risk on in my portfolio -- that's a dynamic number as well. you need to just find losses you're comfortable with and NOT let them get out of control. If there's doubt, bail.

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Hmmm. There is no free lunch right :)

Another alternative would just do a deep ITM call but not a 90+ delta. Maybe something more in the high 70 or low 80 delta range.

Actually I like MSFT. Look at the returns. The commisions may kill it but the returns are not that different than AAPL if you are getting $5 a short call contract.

A few more questions/comments:

1. You won't realize that $5 profit right because you roll it each Thurs. Aren't you only realizing like $3 to $4 of that short profit?

2. What is your plan if you do get a big first week drop? In this example let's say AAPL drops $40 in one week. Not that crazy with how its going lately.

3. Did you say you would ever roll the weekly short mid week to a lower strike?

Thanks.

Richard

I haven't looked a MSFT -- it might be a great candidate (it wasn't last spring).

As far as realizing the profit, I just maximize the roll, I try to realize as much as the $5.00 as I can. For instance, last week I NETTED $5.22 after the roll, and then gained another $2.50 rolling down this week. But what's the cost to that? Oh yeah, the underlying dropped $25.00.

As for the "big first week" drop. If there's going to be a big drop, I'd rather it be in the first week as there is still plenty of time to sell premium and/or for the price to rebound. The question comes though, at what point do you take your losses and go? And all I can say is there is no hard line, I run a risk adjusted portfolio, where at NO TIME can I ever have any realistic chance of a 10% or more drop on the whole portfolio. That gives me some flexibility on trades like this -- maybe one month I could tolerate a 30% or even a 40% drop in the call, depending on position size, weighting, and how risky the other positions are. It's impossible for me to say at what point would I close and move on in general. I can tell you right now, if AAPL drops below 630 this week, I'm out. But that's just this week.

Quite likely, if I have this CC on, then I have some sort of other hedge on against it -- either something as simple as a DOTM put, a vertical put spread, maybe an ATM IC on a couple other highly correlated stocks.

I would NEVER have this as the only trade in my portfolio, having 50% of my money on it. Ever. Me personally, I would never have this trade make up more than 10%, and ideally not more than 5%, of a portfolio. Let's say it is 5% of my portfolio? What if AAPL drops 200 points? Well, worst case, I lose 5%. (I would not let it get that bad). Risk tolerance is a creature of ALL of the trades you have on, not just one.

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Again, depends on the drop, the corresponding drop in the price, and how much premium I can get. I have done any and all.

For instance, on AAPL, last week when it dropped from 680-660, I did just roll middle week and grabbed another $3.00 in premium.

As I had only on a half position, today I actually averaged down when AAPL hit 652, I doubled up my position for $68.00. So one at $91.50, and a second at $68.00. That averages out to 79.75. With the premium I've already gained, I'm actually quite happy with the position. My current "panic" point, which will last to Thursday (when I roll) is around 630.

At 630, I would project the value of my call to be around $48-$50. I've already collected just north of $15.00 in premium (after accounting for the averaging down). That's $65.00. So at 630, if I exited, I would be facing about a 22% loss. And remember, earlier in the option, I'm more risk tolerant as the price can rebound, later on, less so.

So, what do I do when things go south?

1. Look at averaging down

2. Look at rolling the short down for more premium

3. Look to exit

And, I can hold some losers longer, depending on the overall risk on in my portfolio -- that's a dynamic number as well. you need to just find losses you're comfortable with and NOT let them get out of control. If there's doubt, bail.

Thanks Chris. I am thinking rather than a OTM put as a hedge maybe not going to deep ITM on the call and maybe looking at more of an 80 type delta far enough out that the theta is low. seems like cheaper insurance than the put.

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Thanks Chris. I am thinking rather than a OTM put as a hedge maybe not going to deep ITM on the call and maybe looking at more of an 80 type delta far enough out that the theta is low. seems like cheaper insurance than the put.

I don't have access to old data, but on Thurs I think the premium was closer to .22 on a weekly that was around .30 OTM. .30 of around $30 is around 1%. This a stock that doesn't often have large moves. If you make 1.5% on it a week because it went up around $.50 than I think that is good. However perhaps you can check TOS thinkback. (you'd need the high low not the Thurs close).

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So I'm back to give up my screener information. I have a couple of different screening tools, but pretty much do the same thing on both.

The one I like is not flashy and very basic. I have to do quite a bit of manual work myself, BUT it's not too bad. Forgive me for how basic this is.

So how did I come up with the FXEN play? Simple. I made it seem as thought I looked for an energy play, but I really didn't I was looking for home run plays just for a good example. So here is my screen from the Schwab tool (they use LiquidPoint) and the results that were posted. I then looked at some of them and found one. Note that I could have

selected a sector or an industry if I so chose. I do sometimes. Also the image shows 12%, but the results are from 10%.

post-435-0-77860500-1349219575_thumb.jpgpost-435-0-41086700-1349219592_thumb.jpg

This is a very agressive looking for a 10% return in 18 days (the FXEN is actually 12.82% if even, 14.5% if called). I normally don't find anything that I really like in that short of a timeframe. For quick jobs like that, I loke to look for something going up. FXEN isn't something I would normally do this trade on since it has not made a profit, BUT since they don't report earnings or anything in the next month and I don't see energy colapsing, it may be a good *speculative* trade to try and make a quick 12% on. YMMV

So anyway, I usually do something like the screener 3 to find decent companies to trade. Looking for 10% over 2 months. That's still pretty agressive, but for these types of trades, I'm looking for those. I set the P/E to being at least 5 so that I only get profitable companies.

post-435-0-30433200-1349219606_thumb.jpg

Right now that screen really doesn't populate anything that I'm really digging. Don't ever feel like you HAVE to have a covered call going on. Also, this screen usually only comes back with 10 or so results, easy enough to process manually for myself. I then do chart work and other reasearch. Usually I can exclude a company very quickly from this. I've only made a handful of covered calls like these this year. I could probably make better use of these tools, but for the most part, I write calls against core holdings (and I've not been on this long enough to have a ton to write against), but for my Roth IRA, this works well for me.

Edited by trhanson

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Thanks Tyler. Interesting information.

Does anyone know if IB or TOS has a similar screening capability? I have seen screeners on stocks but not on options like this.

TDAmeritrade does -- most major brokers do (and TOS is through TDAmeritrade)

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    • By Reel Ken
      Before I get into "new ground" in this article, let me recap my basic objection to covered calls.
      Old News
      One hopes that the investor has carefully selected a portfolio of stocks. One would also like to think that the investor's selected portfolio will, at least in their mind, outperform a simple index fund ... such as the SPDR S&P 500 ETF (SPY). For if the investor doesn't think they will outperform the broad index ... why not just buy the index and make life simpler?

      And the same can be said for individual stocks, such as any of the FAANG stocks. If the investor doesn't believe their selection will outperform a broad based, representative ETF, such as the Invesco QQQ NASDAQ ETF (QQQQ), then just go out and buy the ETF.

      Now that leads to my dislike of covered calls. It is not based upon a conclusion that one can or can't make money. That's irrelevant. It's more of a logical argument than a statistical argument. Simply stated it is:

      If one sells a call, then it makes sense to sell a call against an underlying that is least likely to be over-run rather than end up losing money

      I won't go into this in the level of detail of my previous article other than to suggest that one sell a call against an index or index based ETF rather than the specific stock the investor has so carefully chosen and expects to outperform the index.
       
      New Approach
      But enough of "old news". Let's turn our attention to more fertile ground. A "different" approach to selling calls, covered, naked or otherwise.

      Let's say one wants to sell a call against the SPDR S&P 500 ETF (SPY). The first step one takes is to select the applicable strike and expiry. As I write this SPY is trading around $270.5 and let's say I'm considering selling a monthly call 1% out-of-the-money. So, I look at the November 16th expiry and a strike of $273.5. Not quite a month and not quite 1%, but we're talking concept here. After all, who knows where SPY will be when you actually read this.

      But before we get into specifics, I must stress that I'm using current option prices when volatility is relatively elevated. This means that any example will look a little more dramatic than it might when volatility is more normal. Additionally, I would be hesitant to sell a call after a recent , big drop ... preferring after a big rise ... but that's another story.
       
      The Gamble
      So, using SPY=$270.50 plus current volatility plus November 16th expiry and about 1% OTM we find a premium credit of $3.60.

      Now the results of this strategy are pretty easy to understand. If SPY goes down or up no higher than $273.50 then one pockets the premium of $3.60.

      On the other hand, if SPY goes up higher than $273.50, then a "give-back" commences and if SPY goes above $277.10 ($273.50 strike plus $3.60 premium = $277.10) the "give-back" is total and losses will commence.

      Now for SPY to go from its current price of $270.50 to $277.10 would represent a rise of slightly less than 2.5%. That, quite simply, is the gamble. In the particular market we face, today, that might be a losing gamble, but that's the gamble one takes.
       
      The Tweak
      There are multiple possible tweaks, but I'll just detail two of them. Both designed to effect a slightly different result. I suggest each reader "play" with the idea to find their comfort level and what matches their objectives. Here goes:

      Instead of selling one call at a strike of $273.50 for a credit of $3.60 ... sell a ratio call spread. Now a ratio call spread is one of the simplest of the more exotic option strategies. It consists of two legs as follows;
      First leg is a buy of a call. that call can be ITM, OTM or ATM. Second leg is selling twice as many calls at a higher strike. The actual strike selected for these call-writes can be selected to break-even, produce a credit or a debit. It all depends upon the objective. Now, for purposes of the "tweak" I want to improve upon the results of a simple covered call that produces $3.60 of premium at a strike of $273.50. That goal will determine the strikes for both legs.
       
      Tweak #1
      Instead of selling a simple call at a strike of $273.50 for $3.60 I employ the following ratio;
      Buy a long call ITM at a strike of $269.50 for $5.90 Sell 2x short calls at a strike of $271.50 for a credit of $4.71 each for a total net credit of $9.42. Here's what happens. The net credit is $3.52 ($9.42 minus $5.90). That's close enough to the targeted $3.60.

      So, If SPY drops, the minimum one gains is $3.52. I say minimum because leg #1, the long call is slightly in-the-money. So, if SPY drops below $270.5 but above $269.50, one picks up not only the $3.52 net premium credit, but some value from the long call. By example, if SPY dropped only 50 cents and landed at $270, the total gain would be $4.02 ... $3.52 from the net credit and $.50 from the long call.

      Now, what if SPY rises? Well, we are still working with a net credit of $ 3.52. However, if SPY lands anywhere below the two short calls at $271.50, the long call goes further ITM increasing the gains.

      So, let's say SPY moves up and lands precisely at $271.50. Well, we have the $3.52 credit plus another $2 ITM for a total gain of $5.52.

      What if SPY rises above the upper strikes of $271.50. Well there is a "give- back" of the $2 ITM from the lower leg long call. If SPY rises to $273.50 the "give-back" is 100% and one is simply left with the $3.52 net credit.

      If SPY rises above $273.50, the position is net short and one starts to lose the $3.52 initial credit. I SPY goes as high as $277.02, then all is lost and one ends up a loser on rises above that level. But here's the key ... they lose, but they lose no more than they would have lost on a simple covered call or naked call.

      So, the result is pretty simple. The "tweak #1" will outperform a simple covered call if SPY lands anywhere from $269.50 to $273.50 and equal (minus 8 cents) the covered call on all other situations up or down.

      Perhaps a graphical representation would be helpful:
       


      Tweak #2
      The concept is the same only the objective is slightly different. Instead of trying  to make additional gains on advances up to the covered call strike of $$273.50, we can look to raise the break-even and loss points. So...
      Buy the first leg at a strike ATM instead of ITM at $270.5. This costs $5.51. Sell the 2x second leg at a strike of $272.50 for a credit of $4.35 each and a total credit of $8.70 The net credit is $3.20 instead of a simple call-write of $3.60. 
       
      What we end up doing is gain on any rise above ATM of $270.50 up to the second leg at $272.50. The "give-back" starts at $272.50 and isn't complete until SPY= $274.50 and the "break-even" is moved upward from $277.10 to $277.70.

      Here's how it looks when compared to a simple call-write and tweak #1.


       
      Summary
      With a little bit of imagination and some work one can easily find alternatives to the simple call-write .. whether the call-write is covered or naked.

      I've illustrated two ratio tweaks to point out how one can tailor the outcome to meet almost any objective.

      The first tweak had, as an objective, to make more if SPY didn't reach the strike point. Tweak #2 was designed to raise strike point to lesson the chances of being over-run.

      Both tweaks gave up a slight bit on the lower end, but that's not a result of any inherent disadvantage. it is a result of the fact that SPY option strikes are in 1/2 dollar increments and the best one can do is get close.  

      There are infinite possibilities one just needs to be willing to put on a thinking cap and find what fits them. 

      The important thing to take away from this is  ... before ... one writes a simple call ... look at the ratio spreads and determine if there's a spread that can give you a little more than "plain vanilla". In most cases it will.

      Ken Reel is a well known and respected Seeking Alpha Contributor with over 100 articles. He has worked in the financial service industry for 40 years. Ken's area of expertise is risk management and complex financial products. He has been a frequent speaker, on behalf of many financial firms, to financial professionals across the country. He has extensive experience in statistics and actuarial science.
       
    • By Michael C. Thomsett
      Two primary flaws are found in covered calls, and these should be well understood by anyone decided to sell a call. First is the potential lost opportunity risk. If the underlying price rises far above the strike and the call is exercised, shares are called away – often well below current market value. A covered call writer needs to understand this risk and accept it in exchange for consistent income from the position.

      A second flow is that profits are always limited. The maximum profit is the premium received for selling the call or calls; however, a very real risk of net loss also exists. If the underlying price falls below net basis, a paper loss results. This means a writer has to either realize the loss or wait it out in the hope that price will rebound in the near future. For example, a trader buys 100 shares at $40 and sells a call with a 42.50 strike, expiring in two months. Net premium received is 3 ($300). The net basis is $37 per share (purchase price minus premium received). If the underlying price falls to $32 per share, the trader allows the call to expire worthless, but now has a paper loss of 5 ($500). Should the trader sell shares and cut losses, sell another covered call, or wait it out in the belief the price will turn around?

      The outcome should compare a limited maximum profit to unlimited possible losses. The risk is no greater than just owning shares, but it remains a risk just the same. A solution is to focus on underlying issues with exceptionally strong fundamentals (high dividend yield, 10 years of increasing dividends per share, annual high/low P/E between 25 and 10, growing revenue and net return, and a level or declining debt to total capitalization ratio). Strong fundamentals reduce volatility in stock prices over time, making covered calls safer than those for stocks with high volatility or erratic swings. But this is a deferred factor, not something seen to have an immediate impact:

      Fundamentals matter, but it takes time for the market to recognize and fully absorb the improvement in a sector’s fundamentals. When the market is not perfectly efficient, the firm’s market value can differ from its fundamental value. (Zhang, D. (2003). Intangible assets and stock trading strategies. Managerial Finance, 29 (10), 38-56)

      In other words, markets are inefficient. We hear this said a lot, but many people do not appreciate the meaning of the observation. Covered calls are not sure things and market inefficiency makes covered call writing higher-risk at times than options traders might believe. This is one reason n it makes sense to focus on very short-term expiration cycles. The longer a short option is left open, the greater the risk of unexpected and undesirable price movement. With expiration in one to two weeks at the most, time decay makes profitability more likely than the longer-term option selections.

      Based on the dollar amount received for selling options, many prefer to go out two or three months (or more). But in comparing short-term and longer-term options on an annualized basis, the shorter-term option yields better net returns. In other words, selling 8 two-week options is more profitable than selling two 8-week options. The dollar value of premium can be deceptive, and the only way to make valid comparisons is to restate returns on the annualized basis. A second advantage in the shorter-term option is rapid time decay, reducing risk exposure and allowing traders to roll trading capital over many times to avoid the unexpected.

      It also makes sense to avoid holding open covered calls in two conditions. First is quarterly dividend date. If a covered call is open in the days immediately prior to ex-dividend date and the call is in the money, traders can execute a dividend capture strategy, call away your shares, earn a quarterly dividend in one or two days, and then dispose of shares. This means you do not earn the dividend and you lose shares you want to keep. The second date to avoid is the day of quarterly earnings announcements. In case of an earnings surprise, the underlying can move in an unexpected way, often exaggerating the response to the surprise itself and leading to early exercise.

      In any strategy, even the assumed “sure thing” of a covered call, risk assessment and equally important risk awareness should be taken into account in judging a position. What is your exit strategy with the covered call? One conservative approach is to close a position when a certain percentage of profits are realized; but options traders know that setting goals is easier than following them. It often is too tempting to hold off closing in the hope of more profits tomorrow or next week. No one can know for sure when profits will suddenly turn into losses, so setting a conservative goal and then taking action when that goal is reached, is a wise method for avoiding losses.

      The lesson worth remembering in this is that there are no sure things in any form of trading. It’s true than covered calls are wonderfully consistent cash cows for traders, but anything can go wrong at any time, so traders need to (a) diversify risk exposure, (b) know the true risks to any strategy, and (c) limit exposure by time to expiration. Know when to take profits and set your rules. Then follow them consistently.

      Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his websiteat Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.

      Related articles:
      Uncovering The Covered Call Covered Calls –Does Rolling Forward Mean Higher Risk? Leverage With A Poor Man’s Covered Call 2 Tweaks To Covered Calls And Naked Calls Dangers Of The Covered Call
    • By GavinMcMaster
      The investor then sells a call option over those shares in exchange for collecting a premium. 
       
      One call option contract represents 100 shares, so investors can sell multiple call options if they have a particularly large stock holding. 
       
      Covered calls have been shown to outperform pure stock ownership over the long term while also decreasing volatility.  
       
      Based on data provided by the CBOE, we can see that BXM (CBOE S&P 500 Buy Write Index) has significantly outperformed the S&P 500 over the tracking period of 1986 to 2014.  
       
       
       
      Covered calls work well on blue chip, low volatile stocks. This way you can generate a tidy sum from selling the call options and also receive a healthy dividend while you own the stock. 
       
      Here are two stocks that meet that criteria: 
       
      INTC
       
      Intel has had a tough run of it lately with the trade war having a big impact on the stock price. There are still risk ahead for the chip maker but it seems to have put in a short-term bottom for now.
       
      After dropping 27% in April and May, the stock has recovered and is now above a rising 20-day moving average.
       
      Conservative traders may want to wait for a successful retest of the 20-day line before making a trade.
       

       
      Volatility isn’t as high as it has been recently, but at 25% for a Dow stock, there is some value there for option sellers.
       
      The stock also pays a nice 2.66% dividend so investors can achieve some nice income while they hold the stock.
       
      By combining stock ownership with covered call trading, investors can further boost the income potential from this semiconductor stock. 
       
      With the stock currently trading at $47.21, traders could sell an August 21st $49 Call for $1.27. 
       
      Such a trade would forego any capital gains above $49, but would increase the income potential by another 15.90% per annum. 
       
      MMM 
       
      3M Corporation is another stock that’s had a tough run lately.
       
      This Dow component is another stock that dropped around 27% in the April-May period.
       
      Like INTC, the stock has bounced off the low and is holding above a now rising 20-day moving average.
       
      MMM pays a very healthy dividend around 3.37% and is a Dividend King, having raised dividends for more than 50 consecutive years.
       
      Implied volatility is currently around 25%, having been as low as 15% and as high as 35% in the last year. 
       
      Traders wanting to increase the yield from their portfolio could sell an August 21st $180 call for $3.85 which would add another 13.1% per annum income potential to the holding. 
       
      Join me for a webinar on Saturday, where I’ll be sharing my market analysis and also looking at more trade ideas such as this.
       
      As always, do your own due diligence and trade safe! 

      Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. He likes to focus on short volatility strategies. Gavin has written 5 books on options trading, 3 of which were bestsellers. He launched Options Trading IQ in 2010 to teach people how to trade options and eliminate all the Bullsh*t that’s out there. You can follow Gavin on Twitter. 

      Related Articles:
      Uncovering The Covered Call Covered Calls –Does Rolling Forward Mean Higher Risk? Leverage With A Poor Man’s Covered Call 2 Tweaks To Covered Calls And Naked Calls Dangers Of The Covered Call Exercise Risk Of Uncovered Calls  
    • By Michael C. Thomsett
      1. Risks are low, but so are maximum profits
      The risks of covered calls are low, without any doubt. Properly selected calls – slightly out of the money, expiring sooner rather than later – are going to yield double-digit annualized returns. But on the other side of this trade is a specific limitation of profits. The most profit you can earn on the call is the call premium; additional profits come from capital gains and dividends, adding up to a potentially substantial number. But the profit on the call itself is very limited. Even if the capital gain is a nice high number, it can only go so far. For many, the best time to open a covered call is when paper profits have accumulated already, and exercise would combine call premium with a big capital gain in the underlying.
       
      2. If underlying declines too far, you have a paper loss
      A loss is possible. Too often, traders overlook what happens if the underlying tumbles. With recent stock market volatility, traders have had a wakeup call in many cases, discovering that their sure thing was not all that sure. For example, Amazon.com (AMZN), a favorite among options sellers, was at $1,775 on December 10. Two weeks later, it had fallen to $1,350 per share, a drop of 425 points. If a trader had purchased 100 shares at $1,775 and sold a one-month ATM contract for 85, that would seem liked a perfectly reasonable buffer, under normal circumstances. But over two weeks, the loss in stock of $42,500, adjusted by option premium of $8,500, translates to a paper loss of $34,000. The stock rebounded, of course, but on that day of the drop, the once-safe covered call would have to be perceived with more caution.
       
      3. Recovering from a loss might take time or require facing higher risks
      The time required for a depreciated stock to rebound is going to vary. Amazon tends to act with high volatility, making options richer than many other choices, and potentially likely to rebound quickly. But there are no promises. Some stocks decline and stay down for a long time. For example, IBM was at over $150 per share at the beginning of October. By December 26, it ended up at under $114, a difference of 36 points, or a 24% drop in value per share. A trader selling an ATM covered call expiring in October at the strike of 150 would have made a profit of about $150. When this expired worthless the stock was worth about $130 per share. The $150 profit on the call was offset by a loss of $2,000 on stock, a net drop of $1,850. Waiting for the stock to rebound was difficult as the stock continued falling another 20 points to a low of December 24 of about $100 per share. When will this recover? Given the degree of paper loss, a recovery strategy (for example, selling uncovered puts) would expose a trader to continuing risk without any guarantee of getting back the lost value.
       
      4. The danger of converting to an uncovered position should not be ignored
      Traders learn more from mistakes and surprises than from matters going as expected. For example, executing as series of recurring trades requires diligence and observation of trade timing. For example, a trader buys 100 shares and sells an ATM covered call expiring in two weeks. One week later, the underlying has jumped 25% in value. The trader decides to take profits and sells shares. However, in overlooking the open short call, the trader now is left with a problem. The covered call has been converted to an uncovered call. Making matters worse, with the big move in the underlying, the short call is in the money – and the stock is moving up every day. Chances are that this position will be exercised, wiping out the profit on stock and more, possibly turning the entire trade into a net loss. 
       
      5. Being classified a pattern day trader has consequences
      The “pattern day trader” rule is that if you execute trades on the same underlying four times or more within five consecutive trading days, you come under scrutiny and probably will be labeled a pattern day trader. Given the nature of options trading, it would not be difficult for these volumes of trades to occur. Once your broker classifies you as a patter day trader, you are required to maintain at least $25,000 in your margin account. This is bad enough; but getting the label removed requires a few steps and could be difficult if not impossible. Before embarking on a high volume of trading activity, study the rules and take steps to avoid being viewed as a pattern day trader. 
       
      6. Potential tax consequences include losing long-term tax treatment
      One oddity of options taxation is the “qualified covered call” rule. You can sell a call at any strike you want; but if you pick a strike two levels below the current price of the underlying, it probably is an unqualified covered call. This means the count toward the one-year holding period for long-term capital gains treatment is tolled and will not start again until the unqualified call is bought to close. Here’s an example: You bought stock 8 months ago for $43 per share and currently it is worth $65. You sell a covered call expiring in 5 months for a 55 strike. The rationale is that premium is rich, and exercise would produce profit in both the call and the underlying. Because the total holding period at expiration would be 13 months, it would be a long-term capital gain, right? No. Because the covered call was unqualified, the count toward the one-year hold is stopped until the call expires, is closed, or gets exercised. Even if exercise occurs on the last trading day 13 months after you bought stock, the 12-point capital gain will be short-term.
       
      Options trading is always complicated; but many traders think the covered call is easily understood and low-risk. That is true to a degree, but some potential problems can make the position less attractive. It does not have to be as complicated at it might seem, as long as you are aware of the possibilities above and take steps to avoid problems.

      Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.
       
    • By GavinMcMaster
      That’s fine if you’re super bullish on AAPL and are happy with that exposure, but it’s not great diversification.
       
      Thankfully there is a way to trade this popular income strategy and still maintain some level of diversification.
       
      A poor man’s covered call is like a regular covered call but requires only a fraction. It’s like taking a leveraged position, so the returns in percentage terms will be amplified.
       
      Below are some advantages and disadvantages of a poor man’s covered call over a regular covered call.
       
       

      I like using this strategy with ETF’s, that way you have built in diversification.
       
      For examples, I could set up a pretty well diversified portfolio by trading poor man’s covered calls on the following ETFS:
       
      Bonds – TLT
      Real Estate – IYR
      US Stocks – SPY
      Emerging Markets - EEM
       
      With 4 underlying ETFs and not a whole lot of capital, I have set up a diversified portfolio that generates income through selling call options.
       
      Let’s look at some examples:
       
      AAPL
       
      Earlier we looked at the amount of capital required for one covered call trade on AAPL stock which would be around $17,300.
       
      Let’s compare a standard covered call with a poor man’s covered call:
       
      AAPL COVERED CALL
       
      Trade Date: Feb 15th, 2018
       
      AAPL Price: $172.99
       
      Trade Details:
      Buy 100 AAPL Shares @$172.99
      Sell 1 March 16th, 2018 $180 Call @ $1.60
       
      Total Paid: $17,139
       
      Fast forward to March 10th and the AAPL shares are now worth $17,985 and the call has only gone up to $1.71. That means the total position is now worth $17,814 for a gain of $675.
       
      This represents a gain of 3.94%. Not bad!
       
      AAPL POOR MAN’S COVERED CALL
       
      Let’s now take a look at how the poor man’s covered call has performed. Instead of forking out $17,299 for 100 shares, we use an in-the-money LEAP call option.
       
      Trade Date: Feb 15th, 2018
       
      AAPL Price: $172.99
       
      Trade Details:
      Buy1 January 17th, 2020 $140 Call @ $43.00
      Sell 1 March 16th, 2018 $180 Call @ $1.60
       
      Total Paid: $4,140
       
      Let’s see how this position compares on March 10th. The $140 call has increase in value from $43 to $49.50 and the short call from $1.60 to $1.71.
       
      The total position is now worth $4,779 for a total gain of $639 which represents a percentage gain of 15.43%.
       
      By utilizing the poor man’s covered call, we have managed to generate a similar dollar return, while using only a fraction of the capital.
       

       
      Let’s now take a look at a time when AAPL stock went down.
       
      AAPL COVERED CALL
       
      Trade Date: Jan 29th, 2018
       
      AAPL Price: $167.28
       
      Trade Details:
      Buy 100 AAPL Shares @$167.28
      Sell 1 March 16th, 2018 $175 Call @ $4.35
       
      Total Paid: $16,293
       
      On Feb 9th, AAPL reached a low of $150.24 and the March $175 call had dropped to $0.50.
       
      The net position was worth $14,974, a decline of $1,319 or 8.10%.
       
      AAPL POOR MAN’S COVERED CALL
       
      Let’s now take a look at how the poor man’s covered call held up.
       
      Trade Date: Feb 15th, 2018
       
      AAPL Price: $172.99
       
      Trade Details:
      Buy 1 January 17th, 2020 $140 Call @ $41.70
      Sell 1 March 16th, 2018 $175 Call @ $4.35
       
      Total Paid: $3,735
       
      On Feb 9th, with AAPL trading at $150.24, the LEAP call had dropped to $31.35. With the short call trading at $0.50, the net position was worth $3,085 for a loss of $650.
       
      This loss represents a -17.40% return on capital at risk which is worse in percentage terms than the regular covered call.
       
      BUT, the dollar value loss is only half that of the regular covered call. Part of the reason for this is the rise in volatility, which would have given a small benefit to the long call holder.
       
      It doesn’t always work out like this, but in both of these examples, the poor man’s covered call was the better trade. In the first instance, the poor man’s covered call made a similar return while using much less capital. In the second example, the dollar loss was much less, half in fact, than the regular covered call.
       
      Poor man’s covered calls are one of my favorite trading strategies. Traders can achieve excellent returns, but they need to be aware that percentage losses on the downside are magnified as well.
       
      If you want to check out a detailed example of a poor man’s covered call that played out over the course of a year, you can do so here.
       
      Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. He likes to focus on short volatility strategies. Gavin has written 5 books on options trading, 3 of which were bestsellers. He launched Options Trading IQ in 2010 to teach people how to trade options and eliminate all the Bullsh*t that’s out there. You can follow Gavin on Twitter. 
    • By Michael C. Thomsett
      The forward roll works because a later-expiring contract at the same strike is always worth more, due to higher time value. So you can always change out the short position profitably.You can roll forward to a later option with a strike higher, in which case it is more difficult to create a net credit. However, if you are exchanging the current strike for one five points higher and you lose $200 on the deal, what happens if the later strike is exercised? You make a profit:
       
      Extra profit on exercise, five points $500
      Less: loss on the forward roll -200
      Net profit $300
       
      The system of replacing calls is quite simple. However, there are four major pitfalls possible with the forward roll of a short call. These are:
       
      It doesn't always avoid exercise. If the ultimate goal is to avoid exercise, the forward roll is not always successful. For example, if an ex-dividend date occurs before the later call's expiration, the short call might be exercised right before ex-date, a strategy used to get the dividend in addition to a little profit in the 100 shares. Be aware of ex-dates when you roll forward and remember that exercise can happen at any time.
        It might not be worth the delay. If your roll produces less than a net of $50 or so, you have to question whether it is worth it to tie up your position for another week, or more. In some cases, letting exercise happen and getting your 100 shares called away is the most sensible outcome. Compare likely outcomes and remember to compare profitability and the time required to keep your call covered.
        If you don't run the numbers, you could lose on increasing the strike. Make sure you create a profitable situation when you move up one strike as part of your forward roll. For example, if your strike goes up 2 1/2 points but you lose $275 on the net change in value on the deal, you lose money.
        You could create an unqualified covered call. The forward roll can unintentionally set you up with an unqualified covered call. If you are close to getting to long-term capital gains status on your shares of stock, but your roll creates a new position with a strike more than an increment below current market value, the period counting toward favorable long-term treatment stops dead. Investigate the rules for qualified and unqualified covered calls and make sure you don't lose the better tax rate in the deal. A final note: In tracking open covered calls after a roll, be sure to adjust your basis to reflect the exchange of one position for another. When you roll forward, you set up a credit, but it consists of a loss on the current position, versus a net credit  created on the new position. Your basis in the new covered call has to be reduced to account for the net loss.

      Example: You opened a covered call for 5 ($500), but it now is in the money and the premium is 6.25 ($625). You roll forward to a later-expiring option with the same strike, and receive $700. The net credit is $75 ($700-$625). But the loss on the original call was $125 ($500-$625). So your true basis in the net call is 5.75 ($700-$125, or $575). So in order to get a net profit, you have to be able to buy to close below that price.

      Covered call forward rolling is a sensible strategy, but you have to make sure you know all of the rules, and that you have a realistic grasp of what can happen. You want to make sure you know what to expect. Remember, experience is what you get when you were expecting something else.

      Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.

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    • By Reel Ken
      Can You Outperform the Benchmark?
       
      Because investors seemingly take for granted their understanding of Covered Calls they have been reluctant to put them under the microscope. This article will take a little different look at Covered Calls and suggest, perhaps, a more efficient way to accomplish the same goal.
       
      The starting point has to be portfolio makeup. Many investors construct an investment portfolio that they believe will outperform some benchmark such as the S&P500. They don’t expect each and every position in the portfolio to outperform the benchmark --- nobody’s that good--- they just believe that their particular combination will outperform. If they don’t believe they can outperform, then I would suggest their first step should be to buy an ETF such as the SPDR S&P500 ETF (SPY). Even if one has constructed a portfolio combining individual stocks and ETFs one TRUTH remains …. Either they believe their individual selections will outperform a benchmark or they should replicate that benchmark through an ETF.
       
      Let’s start with the investor that believes they can outperform and carefully and diligently selected 20 positions. This investor now wants to 1) hedge against a down market or 2) try to create additional income through Covered Calls. Though they are hedging against a drop, let’s say they want to leave a little room for an upside and so they write Covered Calls on each position with strikes, say, 1% Out-of-the-Money (OTM).
       
      Now, let’s say they picked the 1% OTM strike perfectly and the overall portfolio went up 1%. Great planning … or was it? No portfolio has stocks that move up exactly the same. In any typical portfolio some stocks will do better than others at different times. If everything was the same, why own more than one stock? So, if a portfolio went up 1%, it just makes sense to assume that some stocks went up more than 1%, some less than 1% and some may even have gone down.
       
      That means that though the portfolio went up 1%, some stocks, by virtue of the Covered Calls didn’t realize the growth above 1% and were “called away”. The portfolio is left only with the “under-performers”. As a result, the portfolio didn’t realize its actual potential, though the strikes were apparently, set perfectly.
       
      As a result of this, a carefully structured portfolio will not perform as intended if subjected to Covered Calls. Let me drive this home using a simple two position portfolio as an example. Let’s say that the Covered Calls were 1% OTM. One position goes up 6% and the other goes down 5%. The portfolio gained 1%. However, the Covered Calls capped any individual gains at 1%. As a result, a portfolio that should have gone up 1% actually went down 4%. I call this the “over/under-achiever“ problem.
       
      Now, some will argue that they could just write the OTM strikes at different levels on different stocks. Well, if anyone can pick outperformers in their own portfolio that correctly, why not just junk the underperforming stocks and stick with the outperformers?
       
      There is a better way … a methodology that will enable the investor to reap these excess returns and realize the outperformance they were planning on. It’s nothing earthshattering. It’s nothing difficult. It’s done all the time.
       

       
      If you are not a member yet, you can join our forum discussions for answers to all your options questions.
       
      The Covered Call Alternative
       
      Instead of writing COVERED CALLS on selected positions, use Naked Calls against the benchmark.
       
      So, let’s say that our investor, instead of writing Covered Calls on 20 positions, just wrote a Naked Index Call on the S&P500 Index (SPX). Well, first it’s one trade and not 20 trades. Easier to implement, maintain and less costly … not to mention many more expiry dates. It is also Cash Settled and avoids the problem of having a position being “called away”.
       
      Let’s look at what would happen if the investor’s portfolio outperformed the benchmark and went up, say 1.2% while SPX only went up 1%. Inasmuch as their actual holding was not subjected to any call, they realized the entire 1.2% upswing. Nothing is called away. The SPX, having gone up somewhat less at only 1%, was 100% profit with no give back.
       
      As another example, let’s say that a portfolio went up 2% and the SPX went up only 1.5%. The Naked call on SPX, landing In-the-money .5%, will reduce the overall portfolio value by .5% through a cash debit. Nothing is automatically sold. The investor can either meet that .5% using their available cash or select to sell whatever they want. But, after the smoke clears, their portfolio is still AT LEAST .5% ahead of where it would have been with Covered Calls.
       
      I say AT LEAST because if there were substantial outperformers and some laggards as discussed earlier the net could be much less.
       
      What if the investor didn’t want to hedge all 20 positions and just, say 1/2 the portfolio value? With individual Covered Calls one must select which positions and what strikes. With a Naked Call, just select the appropriate number of calls and it’s done.
       
      This can be extended to individual stocks as well. Let’s sat the investor had a tech stock and wanted to sell a covered call. Well, they either believe their tech stock will outperform QQQ or not. If they believe it will, then just sell a sufficient number of calls on QQQ to mimic the individual position.
       
      What if one has a portfolio that leans more toward small caps, tech, international, etc.? This is easily remedied by writing naked calls on multiple indices. For instance, a portfolio that leans towards small cap, could write naked calls, say 75% on SPX and 25% on RUT. Or whatever ratio reflects the investors regimen.
       
      The Devil is in the Details
       
      But, and this is important when writing naked calls …. Make sure the underlying benchmark (or combination of benchmarks) is representative of your actual holdings. One should avoid a mismatch … unless it is deliberate (and that’s for another article).
       
      The next important point to keep in mind is this method works ONLY if the investor selected portfolio outperforms the benchmark. If the benchmark outperforms the portfolio, they might have been better off with COVERED CALLS. I say “might” because writing Covered Calls always runs the risk of the over/under-achiever problem and one can never know how bad it can get.
       
      What about Covered Calls on an index ETF such as QQQ or SPY? The “over/under achiever” problem doesn’t exist as the ETF, by its very nature, “blends” the individual stocks. But there is one thing you can do to get a better experience if your portfolio is in a taxable account (not an IRA or ROTH).
       
      When one sells (writes) an option on equities, net gain is ordinary income, regardless of holding period and taxed at the highest applicable rate. On the other hand, options on indices such as SPX, RUT and NDX are IRC 1256 contracts and afforded special tax treatment. Any net gains are 60% Long Term Capital Gains and 40% Short Term Capital gains (so called 60/40 rule). This holds even when they are sold short and regardless of holding period. The 60% afforded LTCG can mean a significant reduction in tax, especially to those in higher tax brackets.
       
      Assuming one expects to gain on selling an option, they will pay less tax if they sell the index option (such as SPX) instead of the corresponding equity option (SPY).
       
      Any investor that is selling options on SPY, QQQ or IWM may want to consider switching to SPX, NDX or RUT if the tax savings are significant.
       
      Rounding out the issue, selling naked index calls does impact margin and requires sufficient trading authority. Unless the investor can manage these “hurdles”, then they might as well just default to Covered Calls and hope it works out. When all is said and done, perhaps the additional knowledge and trading authority required for naked calls is the real reason people don’t hear much about these methods.
       
      Summary 
       
      Covered Call strategies are often taken for granted without too much thought. That might work fine for the occasional investor “playing around” or trying a few trades. However, for the serious investor that is considering a long term or repetitive strategy designed to augment income or provide some hedge, Covered Calls present some problems. Selling naked calls on a replicate benchmark through either a single index option or combination of index options will almost surely return better results.
       
      Once you boil it all down, the Naked Call is superior BUT it tests the investor’s equity selection. That is, it’s not about one option versus another, but whether the investor has the requisite skills to assemble a portfolio that can beat a benchmark or combination of benchmarks. If the investor is a chronic underperformer maybe the real answer isn’t Covered Calls versus Naked Calls, but something else… maybe professional money managers or simple index ETFs. On the other hand, if the investor is a solid investor, they have an opportunity to even expand upon that record by abandoning Covered Calls in favor of Naked Calls.
       
      Ken Reel is a well known and respected Seeking Alpha Contributor with over 100 articles. He has worked in the financial service industry for 40 years. Ken's area of expertise is risk management and complex financial products. He has been a frequent speaker, on behalf of many financial firms, to financial professionals across the country. He has extensive experience in statistics and actuarial science.
       
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