Jul 312020

Anybody can invest and get the market rate of return, even my 84 year old grandmother who probably does not even know what stocks are. All you have to do is invest in something like a total stock market index fund. In fact doing this, you will beat around 70% of all the active fund managers.

However, if you want to do better than the market, you better have a plan. Covered Calls is a way to do so.

Covered calls are the most conservative of all the various option strategies. It seems pretty simple but, many people have trouble making money with them. Most of their problems are one of four things: (1) failure to properly screen good CC candidates (2) failure to monitor and manage your positions once in them (3) not being in enough positions to be diverse and (4) not trading with enough money and thus commissions and taxes take most or all of your profits.

(1) Failure to properly screen positions
I use OptionsXpress and they are great, but at the time of this writing, their covered call screener is lacking. The best one I have found is at Option Monitor. It costs only $35 per month and can screen for about twenty different items. The very useful ones that I use that OptionsXpress do not have are percentage in or out of the money, market capitalization, and percentage above or below the 52wk high or low. Paying another service around $60 or more per month so they can use their “special screener” to show you pre-screened choices is a waste of your money.

Some CC writers just starting out (like myself) go to a site like coveredcalls.com and look at the highest yielding CC positions and go to town. This is an absolute recipe for disaster (I lost 40% in three days, luckily I was paper trading). Those stocks are WAY too volatile and are usually tiny medical related companies. A good CC trader should be very picky in which positions he is going to use.

(2) Management
I learned about CC’s from a guy who was trading during the roaring bull market in 1999-2000 and got absolutely slammed when the market crashed. One of the fundamental things he did wrong was that he failed to set STOP orders for his positions and ended up loosing about 70-80% after he couldn’t produce cash for margin calls. Determining your exit strategy is absolutely vital to any CC trader.

Another item that deals with management is rolling up, down, or out. Some CC traders look at just their account balance to see how they are doing.

If your stock has gone down but is still good fundamentally, is rolling down a good option? What if the option has lost all of its time value and rolling out right now can lock in your profit? The bottom line is that you can not just look at the current prices in your account and determine if you should do anything. You need a calculation tool to tell you when you should make management decisions.

I have created and currently use an excel spreadsheet that I think is fantastic. It calculates all the items you would need for a covered call strategy.

The best part is that it automatically updates for the current price of the stock and option
requires internet connection (obviously), Office 2003, and MSN Money Stock Quotes Add-in (free).
If unable to install add-in (a firewall), the program updates via a web query.

So I generally don’t even go to my brokerage website unless making a trade. I simply update the prices in my covered call calculator and see if I need to take any action.

(3) Diversification
Next is how many positions to trade with? This is a very important question. A great book by Burton G Malkiel, A Random Walk Down Wall Street, has a great explanation about the differences between systematic and unsystematic risk. To summarize, systematic risk is the fundamental risk of the market as a whole. Since the market has risk and all stocks follow the market to an extent, systematic risk CAN NOT BE DIVERSIFIED AWAY. Systematic risk is the risk of the market.

Unsystematic risk is the risk of individual companies such as them getting sued, the CEO getting caught lying to shareholders, or inventing a miracle drug. It is this unsystematic risk that can be diversified away. So how many positions should you get into?

The above book has a graph that unsystematic risk goes down exponentially to zero after twenty stocks (how he got twenty I am not sure, but it makes sense). So should you get into twenty positions? No, because CC’s offer downside protection. My personal feeling is at least five, but preferably seven to ten. More than ten is fine, but I think you are all ready diversified enough and are just wasting your time and trading expenses.

If a CC trader does not take diversification into account, he/she is asking for trouble. Just like an “investor” needs to be diversified, so does a covered calls “trader”. Therefore, you need to develop some sort of method to track which industries you are currently in. A great way to do that is to use my covered call calculator. In it there is a section to enter the industry so you do not forget which industries you are all ready invested in.

(4) Money Management
Covered calls have their disadvantages, to think otherwise is naive. One of them is that you have double the amount of trades than just owning stock and thus commissions are around twice as much (but usually more since option commissions are generally higher)

Also, if done outside an IRA, there will be short term capital gain tax rates

“Capital gains on assets held for a year or less are taxed at your ordinary income tax rate (anywhere from 28% to 39.6%, depending on your specific ordinary tax rate).
Capital gains on assets held for more than a year are taxed at a reduced tax rate of 20%”

At the time of this writing, OptionsXpress charges $12.95 for an option buy or sell (but $0 for being called out) and $9.95 for a stock (these are both the active trader discount, both go up to $14.95 without the active, however if you do not qualify for this, you are not following rule #3). So the minimum transaction cost per position is (2x$9.95 + $12.95) $32.85.

The following is an explanation of how much you should invest in per position taking into account taxes and trading costs. Let us assume a standard profit of 3% per position (this is very reasonable). The following is how much money 3% is for different amounts of position values.
– $2000 – $60
– $3000 – $90
– $4000 – $120
– $5000 – $135
Make the decision for yourself, but my cut-off is a minimum of $4500 per position. However, the more the better. (note that this $4500 is the net debt per position i.e. stock minus option premium)

How do you know what the total “cost basis” is for a position before you enter it? Easy, just use my Covered Call Calculator and enter the starting prices and number of contracts and it will tell you.

So the final question is how much money you should you start out with. Based on $4,500 per position and having five positions leaves $11,250 trading on full margin. Note that this does not take into account a positions where you are forced to put more money than $4500 since you are forced to place orders in increments of 100 shares (which is a certainty).

Taking the above into account therefore a good amount of money to begin trading is $15,000. Anything less, you must accept that extra risk.

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