Covered Call Option Writing Strategies: Fishing and Cutting Bait

A mentor of mine, Carl Hullick at Morgan Stanley, once told me - when the markets get tough, go to the movies.

Not the best behaviour for today’s markets; most would say downright denial. But as diversion is sometimes the best medicine, I recently took delivery from Amazon of James Jones’ novel, From Here to Eternity.

The preoccupation of most serious investors at the beginning of the year is, what will the New Year bring and where will markets be, come December 31? This is especially true for 2009 and particularly unclear.

The consensus says: 1) that the economy will be weak the first half of 2009 recovering modestly in the second half responding to both fiscal and monetary stimulus; 2) underweight US treasuries; and 3) buy corporate bonds.

Serious investors also know that consensus is quite often wrong and that conventional wisdom is not that wise. These three ideas lobby in favor of an aggressive and determined new administration succeeding in the long run and we have reason to be optimistic. Family formation is still on the rise and these new families hold the dream of home ownership. In fact the rate of family formation now exceeds the rate of new home construction. University graduates still dream of being entrepreneurs creating new industries and new markets. For these reasons and many others, the current stimulus in the economy will eventually have a positive effect.

So the question is not if, but when? Certainly any experienced investor can be confident in owning dividend paying stocks when the SPY and DIA dividend yield is equal to or greater than 3%, while the ten year US treasury hovers between 2 and 2.5%. But stable to improving GDP in 2H 2009 (against easy comparisons) still may be overly optimistic.

What is an investor to do to make money over the next several months while economies heal and consumers rebuild their balance sheets? I currently use in-the-money to deep-in-the-money call-write strategies with large (mostly DJIA members) dividend-paying companies. The strategy does not work when using a full service broker where commissions will destroy most of the gains. A successful trade involves three commissions totaling about $50-$70 for a 1000 share trade through discount brokers for the two opening positions (buying shares and selling call options), then the desired exercise at option expiration (or possibly before). A minimum of $100,000 is required to be properly diversified.

My selection criteria are as follows:

–limit company selection to dow components (ex. JNJ, WMT) and largest companies in their sector (ex. SLB, ABX)

–minimum calculated gain after commission of 1%

–if the stock trades below down side protection offered by the call premium, the position is closed

(Click this hyperlink for example of spreadsheet details on trades I have executed recently.)

I call this my fish or cut bait strategy. I’m doing something, hopefully productive, and still have plenty of time to go to the movies.

Author’s Disclosures: Author holds positions in JNJ, WMT, SLB, ABX, DNA along with the call writes.

Hillbent.com, Inc. or its affiliates may own positions in the equities mentioned in our reports. We do not receive any compensation from any of the companies covered in our reports.

Comments

[NC Trader:]

How do you deal with the vega vs. time decay of the option? Your strategy would seem to stop out pretty quickly in a volitile market. I've tried it with little success.

Feb 04 10:27 PM

[BMCquebec:]

my concern is getting highest bid price on option and greatest downside protection (5% on less volatile and >10% on volatile prevents excessive stop out) I avoid going too deep in the money (delta to 100) no time value. also avoid going too far out in time where I'm not immediately rewarded with time decay (theta) I personally don't know how to use vega (sensetivity of option to volatility) except now is opportunity for higher premiums with market trending higher shortterm
BMC


On Feb 04 10:27 PM NC Trader wrote:

> How do you deal with the vega vs. time decay of the option? Your
> strategy would seem to stop out pretty quickly in a volitile market.
> I've tried it with little success.

Feb 06 10:12 AM

[claudio.lan...:]

There is another option strategy by Dr Terry Allen called the 36% solution which he does with SPY but uses long term options. All I have seen thus far is same horse different race. Remember the brilliant Phds from Harvard, stanford geniuses in math have lost untold billions of dollars. Wealthy smart successful people have lost billions with bernie baby. It's like when a man goes to the casino with a system. The casinos love them. If you waiting for the line where I write the answer ....I don't have one.

Feb 07 07:54 PM

[CloroxCowboy:]

Your comment about not knowing how to use vega is a little concerning. Unless the position is vega-neutral it's absolutely in your interest to know how to "use" vega. I agree with your two points about not going too deep ITM and selling short dated options, but are you saying you're not taking vega into consideration at all? A spike in IV may not blow up your positions, but it's not something I would ignore either.

Feb 25 05:08 PM

[Fred Thomson:]

his is a great article. Covered Calls has it's known disadvantages which the author points out very well. But a well disciplined covered call trading strategy can be very profitable and will beat stocks in all BUT the strongest bull markets.

Trading costs are another possible disadvantage, but again this can be gotten around by not paying ridiculous amount for trades - try Zecco for goodness sake. I've used them over a year now and they don't have great customer service - but it's is way cheaper.

Also, any covered call trader will need some sort of tool to help him make decisions on when to manipulate his positions. A great tool can be downloaded at coveredcallcalculator....

Mar 01 04:56 PM

[Dark Space:]

Until you can do this trade in any size, DPO seems to get the job done. There are a few other similar ETFs, but DPO follows the DJIA which you use.

Mar 16 05:46 AM