Covered Call Investing

FinanceTrading / Investing

  • Author Owen Trimball
  • Published October 29, 2010
  • Word count 726

Our focus here is going to be using covered calls, but in an investing as an alternative to a short term trading context. And so the name, covered call investing.

The main difference between 'investing' and 'trading' is the fact that traders only plan 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 generally identified as one who has some attachment to the stock and plans to hold for the longer term, with the hope of ultimately receiving some capital gain, plus tax effective income in the form of dividends.

Now that we have now explained the difference, let's explore some covered call investing methods for the longer term investor. The market price of stocks is continually in a dynamic state of rise and fall and it is this which we need to be aware of, but covering the longer term than a trader. As a consequence from a technical analysis perspective, we would be more interested in consulting "weekly" stock charts than "daily" ones. We would draw trendlines, together with horizontal support and resistance lines, across the highs and lows of the weekly bars of the chart. Our aim should be to observe a pattern. Once we recognize such a pattern, then we await an opportunity to buy the stock at the lower end of it.

Our covered call investing strategy would begin with our belief that this stock is close to a strong price support area. The best support areas are those which are confirmed by TWO converging trendlines - for example, an upsloping line along the troughs that converges with a horizontal support line based on where the 'resistance' level has now become support, historically. This is not entirely necessary, but when it is available, it gives us greater confidence.

The initial step in our covered call investing strategy involved selling 'out-of-the-money' naked PUT options with a strike price at the price level at which we are prepared to purchase the stock. You will receive some income 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.

After you have the stock, your second covered call investing step, is to now sell CALL options at a strike price above the stock purchase price. You will collect additional income 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 purchased, are trading in a narrow range over the longer term. You can employ this strategy to receive an extra income stream apart from dividends, since your belief is that you're not likely to receive much in the way of a gain on the shares themselves. As such, if you use a stock screener to try to find optionable stocks with low 'historical volatility' (HV) but also with acceptable liquidity (at least 500,000 shares traded daily) then your covered call investing has a great chance of success. Buy them at the bottom end of the narrow range and sell your call options. Continue doing this every month or whenever you see the opportunity and you are unlikely to be exercised and have your shares called away.

An alternative to a covered call investing strategy of this nature is, that in preference to risking a greater amount of capital by paying for the shares themselves, buy 'leap options' on the stock. These are options which an expiry date of 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 lower amount of capital at risk. Calendar spreads can have different 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.

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