The three "positioning" keys for covered calls

March 21, 2016 09:00 AM

Positioning of strike, expiration and proximity are crucial to the success of a covered call strategy. Selection of the elements requires awareness of the underlying basis, level of volatility, degree 
of time value and proximity between current value of the underlying and strike of the short call. The three elements that define the well-selected covered call: Strike, expiration and proximity.

These are essential to make the covered call profitable and to ensure that risks are kept under control.The covered call is essential to managing portfolio risk. This strategy reduces and controls risk while creating attractive income in addition to the capital gains and dividends in the portfolio. A starting point in the creation of a profitable strategy is smart selection of high-quality stocks based on the fundamentals, notably dividends, P/E ratio, revenue and earnings and debt ratio trends.

Once you have built a portfolio of high-quality stocks, the positioning factors are brought into play to pick an option strategy that works.

Strike selection always should be your starting point. The strike of a covered call should always be higher than your purchase price of the underlying stock. There is one exception: When the net of price per share, minus premium gained from selling the call reduces the basis, a strike may be equal to the purchase price.

The selection of a strike above your basis reduces your market risk. The premium reduces your basis in the underlying while programming in capital gains in the event of exercise. So you end up with three sources of revenue with the covered call: Capital gains, dividends and option premium.

Expiration is the second important key. New traders may be tempted to select further out expirations because of higher premiums. However, your overall premium income will be greater with shorter-term calls. Why? Acceleration of time decay. Theta falls rapidly during the last two months of an option’s life, so picking expirations within this window maximizes outcomes.

Once you annualize returns, you discover that in almost all cases, the shorter-term expirations yield better than longer-term. This is true even though the premium is lower. In other words, you make a better yield selling six two-month calls than two six-month calls.

Proximity of the call’s strike to the current price borders is the third key. When the stock price  is trading near support, the timing is poor for writing covered calls. When the price is close to resistance, timing is better. Price normally is expected to cycle back toward mid-range, so the proximity of strike, combined with strike and expiration, define the well selected covered call.

If your stock price has declined so that exercise would create a net loss, the covered call should not be opened. The strike that produces a net profit and is as close as possible to the current price of the underlying is most likely to yield the highest premium, and to reflect increased implied volatility. For example, “Picking covered calls” shows resistance recently flipping to support in Exxon Mobil (XOM). All highlighted price areas appear outside of the trading range. The first two are identified as good times to sell covered calls. Not only has price risen above resistance, but it also sets up clear reversal signals. The first is a hanging man, a very strong bearish signal. The second is a harami following a long white session and a gap; another bearish signal. These were both confirmed by the Relative Strength Index (RSI) moving into overbought territory.

On the other side of the trade, where timing for a “buy to close” is best, the price levels declined below support. The first highlighted area is an island cluster (marked on both sides by gaps); a strong indication of a coming bullish reversal. The second and third represent dips below the support level and trading range.

About the Author

Michael Thomsett is author of 11 options books and has been trading options for 35 years. He blogs at the CBOE Options Hub and several other sites.