WHAT MAKES A GOOD COVERED CALL STOCK
PART ONE: The Deal. I have written on topic many times before. On wadecookblog.com you will find many postings on this topic and others dealing with many cash flow strategies. Look around.
Picking up on the word, "cash flow," I'll remind you that that strategy is quite different than the standard wisdom being touted in the media stock market marketplace.
So, let me give here a basic covered call strategy. Remember, to me, it's about getting assets to produce income. To do so, we must seek out income from a third-party, outside source. In this case the income will come from the options market.
In short, we buy a stock and then sell an call option—giving someone the right to buy our stock at a set price, on or before a date certain, called the expiration date. To be sure we don't really want to sell our stock, and with the incredible BUY-BACK, we can keep the stock. We're dong this trade to generate income from selling the call option.
An example would help. I'll put here a fairly good stock for this type of trade. CHK, or Chesapeake Energy is good, but maybe not the best.
The stock is at $4.34. 1,000 shares would cost $4,340, or $2,170 on margin, where you only put up one half of the money. There are a few concerns with margin, but space is short. You can read about it elsewhere.
We normally sell the options out a month or so, using the 3rd Friday options as our benchmark. It's August 20th, so we'll look at the September 21st $4 or $4.50 calls. 50¢ incremental strike prices open up many possibilities. The $4.50 strike price is 19¢ X 20¢. The bid and ask. We sell at the bid, or 19¢. We can also place a limit order, and try to get more.
19¢, means $190. That is money in your account in one day. You take in $190, minus commissions. That is your money to leave alone, use it to buy more stocks, or take out and go to a dinner and a movie.
What do you think about that? $190 based on $4,340, or $2,170. It's a nice one month return. Oh, yes we always have to worry about the stock going down in price. In Writing Covered Calls, this is our one major concern. But, if the stock goes up and we get called out, meaning we sell the stock which will happen if the stock goes above $4.50, we would take in another 16¢, or $160. That is the gain for selling the stock. Our total income would be $350.
PART TWO: What makes this work.
I want to rush on to PART Three which will use this same stock and trade to generate weekly profits. I'll give the punch line here. It would be about $300, not just $190. A little more work, but a lot more profits.
Okay, to the matter at hand. How do we find and choose a stock for Writing Covered Calls?
Here is a brief list. I'll write more later, but here are the basics.
- We always have to look at the volatility of the underlying. A serious dip can quickly wipe out our profits. We need to choose stock that is at or near a good support level. Often I call this hard support. We want to find a stock that has dipped and is on an upward trend.
- We need this volatility, however. Movement generates more "fluff" or more pricing into the option premium. In this price range, that would be 25¢ to 50¢ every few days, and then back down 25¢ to 50¢. Upward trend? That would be nice too.
- If we want about a 3% to 10% return, this percentage corresponds quite often to the aount of movement. About 5% would be 20¢ or so, generating the 19¢, or $190. More volatility would make us more money, but there would be more risk.
- In that we like weekly covered calls, there needs to be weekly options. This is easy to check on the site you use for option prices. I use finance.yahoo.com and marketwatch.com. Sometimes, yahoo doesn't have a certain strike prices and I know it should be there, so I go the marketplace.com. This is a DowJones Website.
- We also really like small, incremental stick prices, like 50¢. $3 then $3.50 and then $4. If the stock as the old format, like $2.50, then $5, then $7.50, we usually can't find a suitable profit.
- We have to understand the company. Make sure you're happy with the business of the underlying stock—including its competitors, management and direction.
PART Three: Writing Weekly Covered Calls.
Not only 50¢ incremental strike prices have enhanced the profit potential of Covered Call Writing, but stocks with options with weekly expiration dates has really beefed up the process.
Here are a few things we look for. You can look for these in the upcoming example, and ask a simple question: What would this process or this trade be like without this factor.
- Quite often we find stocks with option prices which hold their value right up to the expiration date.
- Said another way, once we look at the weekly option prices, we notice that the option prices from week to week do not go down or deteriorate rapidly.
So, let's get to the example.
- To see if this is a good trade, we establish a benchmark, which is usually the option price out in a month or so.
- We usually use the third Friday expiration date as it is the busiest, or most crowded.
- We take the bid prices now—even though as time goes by we will not get that price.
- So, we adjust that price. Usually we divide it in half, and for the time we've been doing these, that seems to be closest to the real results we receive.
You'll see this working as we go through the CHK example. Today is Monday, August 20th.
Our benchmark is the $190. Let's see if we can beat that.
8/24. This Friday, the $4.50 calls are 4¢ x 5¢. We'd take in $40 for selling the call at the bid.
8/31. Next Friday, the $4.50 calls are 9¢ x 10¢. Yes, we could sell these now if we don't like taking in only 4¢. But then it's a 2 week trade, not just 5 days.
9/7. the $4.50 calls are 11¢ x 14¢. We'd take in $110, assuming time has not eroded the option premium and assuming the stock price hasn't changed.
9/14. The $4.50 calls are 16¢ x 18¢. We would take in $160.
9/21. The $4.50 calls are 19¢ x 20¢. This is the same as the 19¢ we used as our one-month benchmark.
We add up all of the bids and get $590. Again, taking 1,000 shares time the penny amount of the bids. All of them add up to $590. Now, we knw we won't get $590. Time takes away the bid quite quickly.
So, we divide this $590 by 2, and rounding off, we get $300. Obviously this calculation is not always correct, but it has been pretty close. These numbers can be used to figure out if doing covered calls is a good way to go, and more specifically, whether we should do weekly calls.
We an change anytime we want—and even not do the selling of the call if we're sick or traveling. We might be able to buy-back earlier and get in anther trade, but try as I have, that extra income has be elusive. In this case, I think working the trades to weekly calls works. Again, watch the underlying stock—putting in a stop-loss order around $4 or $4.10.
PART FOUR: What can $4,000 do.
I incorporated into this posting the number of $4,000, as one of your fellow student asked what could be done with $4,000? I get the question a lot. Usually asked this way: How much do I need to get started?
The answer is not that simple. With a smaller amount of money, commissions eat up a larger percent of the profits—as some part of the commission charges are fixed.
Here's the simple question; Is taking $4,000 and making $300 worth your efforts for one month? Knowing what you know, can you do something like this every month? That's up to you.
- Taking margin into account, $4,000 would buy double this amount, or $8,000 worth of stock. With 2,000 shares, not 1,000 shares, you could now sell 20 contracts, not just ten.
- Instead of $300, you'd take in $600.
- Five or six batches like this would generate a possible income of $3,000 or more. Some people could retire or at least move toward retirement with this amount.
- If you only have $2,000 the above trade of 1,000 shares could be done.
So, that's it for now. Feel free to comment or ask more questions.