Covered Calls: Tips to Reduce Risk

By: Dan Keen

The following is an excerpt from Dan Keen's Covered Call Writing: A Low Risk Cash Flow Money Machine

Of the various option strategies available, writing covered calls carries the least risk.  Nevertheless, there is always risk in the stock market, and there are no guarantees.  There are some things to keep in mind that can even reduce risk further.

Avoid Potential "Opportunity Lost" Scenarios
Don’t use covered call plays on rapidly uptrending stocks.  You run the risk of being called out, and you may experience "opportunity lost" by limiting your upside potential.  A better play on rapidly uptrending stocks would be to just purchase the stock outright, or you could buy a call option rather than buy the stock.

Use Margin Wisely
To minimize risk, don’t purchase the underlying stocks on margin, or at the very least, keep your margin loan at a low, manageable amount.  A margin account is a brokerage account where the broker allows you to buy stocks using money they loan you (for which interest is charged).  Any cash and stocks you have in your account are used as collateral.  If you have $4,000 in your account in cash and stocks, you may be able to purchase up to $8,000 worth of stocks.

Using margin can give you more buying power, but it must be used wisely.  If your stocks drop in price, you could be required to send more money to your broker or sell some of your stocks to satisfy the "margin call."  You never want to be in a position where you have to sell a stock just to come up with needed money to satisfy a margin call.  That might force you to sell a stock you don’t want to sell or sell it at a price that is not advantageous.  Leave the use of margin purchases for later when you gain more experience, can take a little more risk, and have a better handle on your covered call strategies.

Speaking of not being forced into selling a stock when you don’t want to in order to satisfy a margin call, this is a good time to remind you to never put any money into the stock market that will ever be needed to pay bills or for family emergencies.  "Murphy's Law" (what can go wrong will go wrong) seems to always be there when it is least wanted.  Our goal is to only sell a stock when we want to, or when we are called out from a carefully thought out covered call position, where we come out a winner.

Your buying power is certainly increased by using margin, but also remember there will be a monthly charge on your account, and that will reduce the amount of profit you are making on your trades.  Usually, however, this will not be a significant amount, compared to the premiums you receive from covered call writing.  If you can buy a stock on margin and generate monthly income from it, the premium you receive in one or two months may be enough to cover the margin interest for a whole year.  Keep your margin loans down to a reasonable amount, and allow plenty of "headroom."  Don’t use up to your maximum margin limit.  Leave a cushion in case some of your stocks drop in price.

Monitor Your Portfolio Daily
Monitor the underlying stocks on which you hold covered call options daily, and be prepared to buy back a call if the stock's fundamentals have severely changed.  One of the nice things about covered call strategy is that checking your stocks once a day is usually sufficient to pick up on any problems, unlike day-trading or other short-term trading where traders are chained to a computer all day keeping an ever vigilant eye on every stock they own.

Make Preservation of Capital Top Priority
Our priorities are to first preserve the capital we have at play in the market, then second to that is making a profit.  Don’t reverse that order of priorities.  If we take too much risk trying to make a profit at the expense of losing a lot of our principal, we will have less money to work with in our next plays.  Be psychologically prepared to buy back any call you sold where the underlying stock has taken a downturn and your forecast is that it will continue to drop.

Establish a stock price at which you will "pull the plug" should the fundamentals on the underlying stock turn nasty.  Do this BEFORE you make the trade, and stick to it.  If the stock drops below your predetermined price, you are reduced to a position of "hoping" that the stock will rise again.  This could be nothing more than wishful thinking.

Pick A Short Time Frame
Write covered calls with expiration dates that are only one or two months out.  Your hope is that the stock will not change significantly before your option expires.  The shorter the time until expiration, the less your risk of having the stock make a sudden move in either direction, in which case you will either suffer a drop in the value of the underlying stock without the freedom to sell the stock, or the stock will soar and you will suffer "opportunity lost."  When an option expires you have the chance to evaluate whether you should sell the stock, write another covered call (perhaps with a higher strike price if the stock has gone up), or if the stock has dropped to wait until the stock rises and the option prices improve before writing another call.  A sector may suddenly become out of favor with investors, and a stock you have in that sector may drop simply because it is unlucky enough to be in that sector.  Before writing another call you can make a determination as to whether or not you want to sell that stock and get out of the sector.

Calculate Yield
Do the math to be sure each trade is profitable before committing to a play.  When only one contract is being sold and the premium being paid is low, be sure that commission fees won't make the trade unprofitable.

Aim for premiums that will pay 10% yields (for both buying the stock and selling the call) after commission fees are taken into consideration.  Also take into consideration your net profit if you are called out.

Low Cost Stocks Increase Yield
Stick with stocks that are around $20 or less to avoid having too much capital tied up in the underlying stock.  The percent return on investment is higher, too, since the premium paid is usually the same for a $10 stock as for a $50 one.

Do At-The-Money Calls
One way to play a covered call is to attempt to get called out on purpose.  Rather than buying a stock with the idea of holding it long term, buy it with the intention of being called out to get a quick kick in income.  The best shot at achieving this is to buy a stock and write a call when the current price of the stock is the same as the call option's strike price (at-the-money) or even slightly above the strike price (in-the-money).  Option prices will be high at these prices, giving the covered call writer a good income.  If you are called out as planned, you get the money back used to purchase the stock (less commissions), the premium is pocketed, and that money can be turned around immediately into another covered call play.

Be Sure It Is A Stock You Want To Own
It's a good idea not to do a covered call play on a stock simply because that stock's options are paying a high premium.  Do your "due diligence" and be sure the stock is one that you wouldn’t mind owning in case you don’t get called out and the stock drops a little, forcing you to hold onto it for a while.

Preventing Uncovered ("Naked") Call Positions
Our experience has been that some online brokers are several days behind in updating account information posted on their Internet sites.  When covered calls expire on Friday, wait until the following Tuesday to check your account to confirm you still own the stock and were not called out of any options you hold.  Otherwise, you may think you were not called out of a stock since Monday morning your online broker portfolio display shows you still have 100 shares in your account, when in fact those shares may have been assigned.  If you then attempt to write what you think is a covered call, you may actually be writing a "naked" call, where there is no stock to cover the deal.  Should that happen (and it has happened to us), you will get a call from your friendly online broker giving you the day to correct the situation, unless your account is approved for naked call writing (the requirements for this are usually that a huge sum of money, $50,000 or more, be in your account and special permission granted).  In this situation, the choices are to either buy the call back and pay a little more for it than you received (the ASK price is always more than the BID price), and cough up another commission fee, or to immediately buy the stock.  If you don’t have enough money in your brokerage account, use electronic funds transfer to move money from your bank account to your brokerage account.

Avoid Trading At the Opening Bell
During the first half hour or so of daily trading, stock and option prices are likely to swing all over the place, and market orders may be executed at undesirable prices.  The people in control of setting market prices have the advantage of seeing all orders placed prior to the open that are waiting for execution.  This will affect the prices they set.  There may also be less liquidity at the market open.  Wait until the dust settles a little before placing any trades, and never place a trade when the market is not open if it is a "market order" rather than a "limit order."  It is also advisable not to place orders near the market's close.

Diversify
At any given time, have covered calls going on companies in different sectors (retail, technology, health and medicine, airlines, etc.).  Sectors come in and out of favor with investors, and this gives added security.  If all the stocks in one sector suddenly become out of favor, you will still own companies in other sectors that will be unaffected.

Keep A Detailed Log
Keep a detailed log of your trades and their results.  Also keep a profile on each company you are playing or considering playing.  Add any important news releases, such as earnings announcements.  A trading journal will help you reflect and evaluate why past trades were successful or unsuccessful.  Write down why you selected a particular stock, and how your covered call play worked.  What was the source where you found this stock?

Watch Reactions To Earnings Reports
A clue as to the future direction of a stock can often be revealed by watching the stock's price as it reacts to earnings reports.  If "the street" is expecting a company to report earnings of 50 cents a share and it reports 70 cents, the stock price would be expected to climb.  Should the opposite occur, take this market reaction as a warning of further price declines.

Similarly, if a company's earnings report shows that earnings fell below analysts expectations, but the stock rallies higher, there is strength in the stock, and future price increases could follow.

Be Aware Of The Overall Market Trend
In addition to the movement of a particular stock, it is important to consider the market direction as a whole.  Has it been trending downward, upward, or trading in a narrow range?  All boats rise as the tide rises, and float lower as the tide recedes.  Since there is a good chance that your stock will be affected by the trend of the market, pay attention to what the overall market is doing.  When the whole market is in a downtrend, it might not be the time to buy stocks. 

The market environment is also affected by economic and political climates.  Traders should always be aware of national news that may affect the market.

Don’t Buck A Stock's Trend
When a stock is in an upward or downward price trend, the tendency is for the stock to continue in that direction for a longer period of time than many people sometimes expect.  Resist writing a call on a stock that is in a downtrend simply because you believe it will turn around, even if some positive news is released on it.  Remember our goal is to write calls which expire in only a month or two.  That doesn’t usually allow sufficient time for a downtrending stock to reverse direction.

Control Your Emotions
Have patience.  Base your covered call decisions on the criteria you have established.  Fear and greed are emotions that attack all of us as we attempt to trade.  Be aware that your emotions may try to sway you into making a bad decision.

Only Use "Play Money" In The Stock Market
We mentioned this earlier, but we want to ensure you take this point seriously.  Never risk money you cannot comfortably afford to loose.  Traders have an old axiom that says, "You never make money with scared money."  In such instances, buy and sell decisions may be made by emotions rather than logic.

Don’t Put All Of Your Eggs In One Basket
At no time should you ever put all of your trading capital into one stock.  It's much too risky.  If you have enough money to buy 500 shares of one stock, buy 100 shares of five different stocks instead.  Resist the temptation to put all your eggs in one basket, no matter how attractive a stock may appear.

Be Suspicious Of Very High Premiums
Finding covered call plays that will generate between 5% and 10% a month return is not difficult.  Lists of stocks on which a covered call play would produce very high premiums can be obtained by using computer software screening or by visiting some covered call Web sites.  But be suspicious when a premium is so high as to give a return of 18%, 20%, even 24% in the near term.  Something unusual could be happening to cause such a high premium.  You may be unable to find any news posted on the stock, but somebody knows something that you don’t!

Our research has shown that many times when an option premium would give a very high yield by writing a covered call, the stock is likely to be a highly speculative one.  Check the P/E ratio; in all likelihood it will be a negative number, indicating that the company has negative earnings.  Such a stock can have its price drop quickly and drastically.  The best advice is to steer clear of plays where the premium seems too good to be true.  We can do quite nicely, thank you, by sticking with more conservative plays, limiting our risk.

Check Open Interest To Ensure Liquidity
We want to be sure there are other people playing a particular options series before we get involved.  This will ensure liquidity so that we won't have any trouble buying or selling the option when we want.  The free Web site of the Chicago Board Options Exchange, www.cboe.com, lists the open interest on every options series.  Open interest is the number of option contracts currently held on a particular option series.

Patience
Although it's fun to enjoy the excitement and action of trading, don’t trade if conditions aren't right.  Wait for the best opportunities.  Analyze the stock fundamentals, technicals, the market environment, and the option premiums.  Take the attitude that you don’t always have to be holding covered call positions.

Buy A Call Back To Avoid "Opportunity Lost"
Once we bought stock in a company that was in the oil industry.  When unexpected favorable news came out on the stock, coupled with a rally in the oil services industry, the stock began rising more than we had anticipated, and went right through the strike price.  We took a chance and bought the call back ("buy to close" the position), hoping that it would continue to rise.  Buying the call back cost more money than was made on the call, since the stock price was now higher and also because another commission fee was incurred.  But that action ended our obligation to hold the stock.  We waited a few days and the stock continued to climb a little, when we sold it at a profit that was slightly better than we would have gotten from writing the covered call, and we avoided "opportunity lost."

When Returns Dwindle, Move Money Into Higher Yielding Plays
A stock can have great options premiums one week and then poor premiums just a short time later.  A poor earnings report, a drop in market volatility, or any one of a number of other factors can change options premiums.  A $13 stock we bought paid us $80 the first time we wrote a covered call, but then dwindled with each successive time we "rolled out" another call, paying $66 the second time, and then $45 the third time.  At the time of the third option expiration, we evaluated the return for the next month out and it was paying even less.  Since the stock was currently sitting at about the price we paid for it, and we had made $191 clear on in the past few months, we decided to sell the stock and move that money into the purchase of another stock whose option premiums would give us a better return.  This was also a wise decision, because options out for the next month were not paying a decent price.  When the dust settled, it totaled a 14% return in about four months.