Covered Call Checklist

The whole idea of the Covered Call, is to find a stock that you like, willing to own, and accept the risk if something should happen. You have to do a few things first.

1) Do your fundamental analysis. In other words, look at the company, their financial statements, make sure that they are a company that can make money for the forseeable future, that their price to earnings ratio is good, and they aren't up to their eyeballs in debt. The point is, any time you go long in a stock, you should know all of these things.

2) Get to know your Greeks. Options variables are Greeks (Delta, Gamma, Theta, Vega and Rho). You don't need to know how to write a screenplay in Greek to get anywhere with options, but be aware, and even more important. Find out what the Implied Volatility of the stock is! http://www.intrepid.com/robertl/stock-vols1.html?q=~robertl/stock-vols1.html has a nice tool to tell you what the historical volatility of your stock is. Important. (Remember we want to sell high volatility, but on the flip side, it means a larger risk owning the stock).

3) Do a little Technical Analysis. Look at the charts. Have Yahoo! charts show you a 10, 40, and 200 Day Simple Moving Address. Is the price above any of these, or below? Look at the Oscillator, is the position over bought? Is it trending upwards, neutral or down (the covered calls work well with neutral and upward trending stocks)? And be sure to look at this on multiple time frames--1 year, 3 months, 5 days, 1 day. It makes a difference.

When you've done all of this, and you've found a stock you like the look of, and is selling for a good price, go long, and sell your options short. A good covered call should yield about 3-4% a month, which adds up over the course of a year. Be sure to keep your eye on them. The short call can offer some downside protection if things should go to far south for you.

CPSL and the Covered Call

After dumping Exxon on its slide down, I had cash to go around. It needed a place to call home. I had decided on CPSL for several reasons.



1) It was trading at a good price $4.40

2) Its current position had not been overbought

3) It had a high Implied Volatility of 59%

4) It's 200 day moving average ranged between 4 and 6 dollars

All of these things made buying Chinese Precision Steel a solid bet for the covered call strategy. At the market open I placed a limit order at $4.45, and executed taking 700 shares at $4.42. I am now long 800 shares (100 from my previous trade), average value at $4.79. Wiping out any pain from my original long position (see previous posts).

September calls @ 5.00 were trading at .45--just shy of two months out. At 7 contracts, that would net me a 10% return for 2 months, or 5% a month. Excellent deal. If they expired worthless, I would still have 800 shares, and could write more calls, and hopefully make more money (I am selling high--volatility--so the call premium is higher). If CPSL should close above 5.00 and my stock get called away, that's more money in my pocket. And, if previous patterns maintain, buy it back after it dips below 5.00 and write some more calls.

Oil's Pullback

Exxon Mobile road the wave of rising oil from 2006 to 2008, with a few minor pullbacks along the way. It rose from around $60 to $95. It was a pretty spectacular ride. I bought in at $75 back at the end of 2006, with no real strategy in mind, other than long (which really isn't much of a strategy when you think about it).

It topped $95 back in 2007, pulled back, and topped $95 again, and right around that time, the market started to turn south. Financials started to get shaky knees from that Parkinsons disease they had, and wouldn't admit to. During that period, oil was on the rise, profits were on the rise, but missing the mark.

XOM played around in the $80's, dancing with itself. And again, XOM began to spike, up to $94, and back down to $88. Making $88 a good place for support, because it looks like it was a prior resistance level (April couldn't break out above 88). XOM spiked back to $94, and back down, making two little mountain shapes--a Double Top.

After a double top is formed, if it breaks below prior support $88 in this case, it is going to drop like a fat kid on a slide.

Unfortunetely I decided to try a new strategy entirely, which required me to liquidate my position in Exxon Mobile. Which I ended up selling for $83.71. I have no long positions in Oil and Gas at this time. So long Exxon, it's been a nice ride.

Options Fundamentals

Fundamentals of the Options Market, by Michale Williams is one of my favorite entry level books. It covers the basics quickly: what is a Call and what is a Put--Long, Short, ITM, ATM, and OTM. So, if you are reading this and have no clue what any of those things are, buy this book, it's a very good resource to have around, especially if you are wanting to get serious about options.

This book also delves into Synthetics in detail, and goes over the building blocks for them. Synthetics let you construct Profit and Loss profiles that are similar to each other, but may reduce risk, or less capital intensive. I'll deal with those more later.

The book outlines a huge number of options strategies for each particular market situation. Including some rather advanced strategies, such as back spreads and front spreads. It also covers market basics, and how exactly that little gnome changes those ticker numbers so fast.

Options Markets also introduces us to Position Trading, another important concept that I will address later. But, very quickly, position trading allows you to identify where your risk is coming from, and how to hedge against it. Beginners and intermediates, this is a good book, and a resource to hang on to.

Options Expired

In July I was long 100 shares of CPSL, that was purchased at an overvalued price, and I had rolled through several calls, until June, when I wrote a July 7.5 call. The third Friday in July came rolling around, and CPSL was trading well below my call's strike price (it was OTM), thus making the call worthless.

Rather than buying back the call to close my position(for .05 and commissions), I let it expire, with no fear that the buyer would choose to exercise the call he purchased (a loosing transaction: strike price - current price = big loss). Monday's opening bell came around, and the -1 (indicating: short) in my portfolio in E*Trade showed that my short call was gone, but 100% of my premium received still remained.

I had a decision to make, wait for this big price swing again moving back up to 7 and 8 dollars (only to capture my original purchase value), continue to sell short term calls and hope it doesn't spike in price on me while I am in a call (I would have to buy back my call in order to sell my stock, but as the price goes up so does the call price), or sell a long term call and forget it?

With the short term calls for 5.0, one month out were trading at .25; and, with 1 contract that doesn't net a whole lot of premium. A long term call, in this case 5.0 Mar'09 calls were selling for 1.30. A bit better for one contract.

Selling short terms didn't make a whole lot of sense to me. So, I eventually decided that if I am going to be long with this stock I might as well stick with it, and make my some winning options plays. I wrote a Mar'09 call, and pocketed the premium and in this case the ticking clock was my friend slowly eroding value. Everything else, I'll take in stride.

Shorting Financials

Several days later, after a mildly successful swing trade from shorting a financial stock, I had kept my eye on everyone else in that sector to see if similar patterns would emerge, and sure enough, they did. Bank of America after bottoming out, started to rise and rise some more when they posted better than expected earnings.

In a matter of a week, the position was over bought on a 5 day basis; the stock had gone from 18 to peak at 34. That's when the stock started to falter. Rather than do something silly, like buy the stock, hoping to capitalize on its magical upward movement, I waited to get on the next mystery tour bus.

At around 30.25, BAC started testing support, the position was still overbought on several time frames from minutes to days, and upward momentum had slowed. I had my sell short order ready for 200 shares of BAC.

My previous swing trade only involved 100 shares for a .25 cent move. Nothing stellar. One way to increase profit is to increase volume. I made use of my margin available to me.

BAC broke resistance, and I sold short 200 shares at 30.03. And like clockwork, the stock began its predicted descent. I closed out my position buying back at 29.75; a few up ticks had me nervous so I sold. However, I was too early on my sell. Several hours later, the stock was down to 27. I had to shrug, but that was my risk tolerance.

Another sucessful trade. Another .25 cent move, but this time, twice the profit. Now we're getting somewhere.

Swing Trades

It was time to take my new technical knowledge and see the wedges and supports. One other item I was looking at was the Oscillator, or how overbought and oversold a position is at a given time. Generally the market is wrong 80% of the time. Given that knowledge I've decided to adopt the strategy of betting against the market, given the right circumstances.

Wells Fargo posted 2Q gains higher than expected, which caused a buying frenzy, and their stock shot up. Prior to the earnings announcement, WFC had dropped off from 23 and change to around 20, only to be over bought on earnings news to close at 27.

I was on high alert. The following day, I started watching WFC on five minute time frames watching for patterns. The upward momentum from the day before carried the stock to above 27.5, but showed sings of slowing and created a support level at 27.12. It tested support twice, and I had a sell short order for 100 shares ready to go, if WFC should fall below resistance.

Since it was an overbought position, it didn't have the upward sustaining motion. And when the irrational market saw the stock dropping, they would all sell in-mass to try and cut their previous losses.

WFC dropped below 27.12; I was slow with my trigger finger (and I am not using all of the sophisticated software I could be using to trade), and my order went through at 26.99. I started watching the ticker; WFC started falling, down to 26.60. And then started heading back up. I decided to enter my buy back order and close out my position, at 29.7482. Giving me a profit of about .25. At a hundred shares: 25$.

Okay, so nothing earth shattering, but I had made a succesful trade and built some confidence. I sold my first stock short, and had used technical analysis to create a strategy with an entrance and an exit. I could have held on for more profit (eventually the stock bottomed at 27.55), but hindsight doesn't need those ugly bifocals.

Technical Analysis

Whether you are a fan and are a rich technician laughing in the face of those who doubt you, a fundamentalist who scoffs at it, or just plain clueless, you need to be, at bare minimum, aware of it. What it is and how it works.

I would recommend Getting Started in Technical Analysis by Schwager. It's a fairly simple approach to the subject, and makes it very approachable for beginners.

Basically, it says that certain historical chart patterns form, and from that reasonable future predictions can be made, barring no fundamental changes. There really is no right or wrong; it's an art form. For some people it's a little to esoteric, they need a mechanical system that can be rigorously tested, and technical analysis is not that.

I am not a die hard technician, but I do find it useful, and every trade I have established using these ideas has made me a profit. I can't complain. There are also a lot of great blogs out there about the subject, Alpha Trends being my favorite.

Options as a Strategic Investment

I finished Options as a Strategic Investment, by McMillan, back in June of this year. I have to recommend this book very highly. However, this book is geared more towards the Intermediate/Advanced options trader. So, unless you have your fundamentals down, hold off on reading this book, but if you are there, or are just curious, it is an excellent book.

I'm not an advanced option trader yet (hoping to get there someday), but I was able to glean a lot of good ideas from this. For example, yesterday I mentioned buying "low and selling--volatility that is." This is an idea direct from McMillan's book.

Volatility will increase the price of an option. There are a myriad of strategies that would allow me to do this, and the book goes into detail about advanced strategies such as back spreads and front spreads. And when I get to that trading level, I will be implementing these ideas.

But again, the idea of volatility can apply to selling covered calls. We buy the underlying security 100 shares of the stock, and the sell 1 OTM contract. The trick is, find a stock that is volatile but currently undervalued, and then sell the option which is overvalued due to the high volatility. This takes some homework, but that's the name of the game.

Lehman Brother's

Buy low sell high--volatility that is. One real secret to success in options is to master the idea of volatility. Buy the low volatility, and sell the high. You'll have to do a bit of research to find the right one though. In my situation, however, I am writing covered calls. I am selling volatility, but I am also long the underlying security, so there is another risk to contend with.

In the covered call situation, the call can provide some downside protection (whereas a simple naked put does not). I found that Lehman Brother's after the end of the first quarter, were getting some unfavorable news coverage, with some nasty news about first time losses, negative earnings, and so on. I felt that the news was unwarranted. Volatility was rising.

The thing I wish I could have done was trade a collar or a strangle. This would have been the ideal strategy for this situation, and would have been very, very lucrative. However, my only option was a covered call.

I bought 100 shares of LEH at 32.49, and wrote an ATM call (I learned from my deep ITM calls) for that month for 3.55. This was a nice fat premium.

A week later, seriously downer news came out about LEH Monday morning before the bell. I decided it was time to unwind the trade, as LEH was gapping down. I sold the stock for a loss, but I ought back my call for .9, giving me a profit on my option of 2.65. This was more than enough to offset my losses on the underlying.

I'll go ahead and say that this was a successful failure. The trade did not turn the 10% profit I was hoping for, but it was managed to prevent serious losses.

Again, this trade needed a differant strategy, collar/strangle, where direction did not matter, but again as a first time trader, I was limited by the tools I had available. I just chalked this one up to as a good learning experience.

CPSL

Once I realized that selling deep in the money calls was not going to get me rich, but really just make me a few pennies to pay the broker, I unrolled all of my current calls for CPSL and MEA. For MEA, it wasn't too bad, although the call had gone up in price, so did the stock. It was a painless. I then sold the 100 shares I was long.

CPSL on the other hand, had been deflating like a bad fart. My call, however, was cheap as dirt to buy back. It had dropped in value from 4.2 to 3.3. I bought it back to close my short position. And took a nice profit.

With CPSL though, I did not liquidate. I stayed long. Perhaps I was waiting for another rebound in the future. The big bounce back up and recapture lost stock value; combined with all of the options I had sold and subsequently bought back at a cheaper price, this wouldn't be too bad a show for someone first starting out--profit.

I then wrote a call OTM at 7.5, and decided that if it got called away I would have a profit, and if the call expired worthless, I would have a few extra bucks. In my first month of trading options, I was able to walk away with a profit. My options had resulted in a %22 return on my initial investment, but this was still offset by my long stock position.

Metallico

A weekend went by, and I was still feeling that I was a rather smart oatmeal cookie about writing my deep ITM call. Really, it takes a lot to say an oatmeal cookie is smart though. The following week, I found another company that had strong growth, good fundamentals, and a stock that just looked like it wanted to go up just for me.

I bought 100 shares of MEA, and wrote another deep ITM call for 5.10. Again, the delta on the call was 1.000, and the call was a month out so there were only pennies of time premium left.

I can say that there is a strategy for trading deep ITM calls, but I wasn't doing it right. You have to be trading more volume than 1 contract to make any meaningful profit. Also, selecting the correct stock is difficult, and probably the best bet is some nifty-fifty software that costs 10 fold what its worth.

Conclusion: first time options traders, your broker may limit your ability to trade those spreads, naked puts and what have you, but there are still places to screw up. Level 1 doesn't mean risk free; in fact, your covered call P&L graph will look something like that of a naked short put.

ITM/OTM at the ATM

I rolled back into a CPSL Call for the same month as before, June, this time for a strike price of 2.50. Capturing, what I thought was a premium, and taking the full value at 4.20. However, I failed to realize, that I had merely captured the intrinsic value of the stock. At that time, the 2.50 call was so deep in the money that it's delta was 1. It behaved just like the stock, and had little to no time and volatility premium.

What a deal I thought, what a deal. I thought I had found the secret to covered call writing. Just keep that up, and I'd be rich faster than anyone else on the planet. I was highly mistaken, but it took me a few more days to realize this.

I guess, words of advice to take away, make sure your strategy is at least plausible. Also virgin option traders--you really need to understand the basics backwards and forwards: Call/Put/Long/Short/ITM/ATM/OTM--please be smart, it's about protection.

Rolling Up/Down

With CPSL on the rise, I wrote an In the Money call for 1.20 with a strike price above my original purchase price. Not a bad move; I was able to capture some intrinsic value in the call, and some volatility.

I was still managing a basket of kittens by the freeway. Not really sure what to do with them. CPSL's momentum dropped, and there was no sustainability to the run up in price. So it went seeking alpha.

I bought to close my short call for .80, capturing a .40 profit. And immediately wrote another call, this time deep in the money. I'm not sure why I did this, but I did. Call it brain flatulence, I suppose.

You can make all the P&L graphs you want, but the real art of options trading is risk management, and managing open positions. You really can only get that through experience.

Options Come and Gone

After a few days, I realized that the only strategy anyone would let me trade was a covered call. I shrugged my shoulders and said, I might as well figure out what the sweet n low is on this guy. I researched the internet, re-read my book and formulated a strategy.

Come the opening of the market I started hunting for that miracle stock that would net me a nice premium for the covered call and be sure not to go down. I ended up selecting CPSL (100 shares) off of the Nasdaq. I bought it on a gap up, hoping for enough forward sustainability.

Once I figured out the proper way to actually enter a covered call order (my god that was maddening; there was not a thing in any book I read on how to enter an order--I guess this is why they don't let beginners sell naked puts); begin with an open and end with a close, and buy or sell as needed.

By the time I figured out the proper procedure CPSL had risen above the strike price I was trying to sell at, no matter. I went ahead and sold one call slightly In the Money. Seconds later, the net credit appeared in my bank account.

I was pretty damn proud of myself, but we all have to start somewhere.

Vacation

Thus far, I have done a simple review of my conception--mis and otherwise--of wealth and wealth creation. Now, that I am into the options portion--this is the real duck and pom fris of the blog. I've outlined my first two years of rather ignorant investing. From here on, things should get interesting, or at least I hope.

Again, the whole purpose of this blog is to show, that anyone can take control of their own finances, and with effort and learning, they can climb their way out of the rat race and into comfort and wealth.

And with that, I leave for vacation for the week. So, not to fear, this blog has not been abandoned.