Setting Up A Covered Call Portfolio-Diversification And Cash Allocation

Includes: PAY, XEC
by: Alan Ellman

A key mission statement in our Blue Collar investment strategy for covered call writing is risk management. An integral component needed to accomplish this goal is diversification and cash allocation. We want to own at least five different stocks in five different industry segments with no single equity or industry representing more than 20% of our portfolio. Here is where to locate industry information in our Blue Collar Investor premium reports:

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Diversification by industry

Note the following:

  • Yellow field identifies industry segment
  • Green field identifies industry rank and in most cases the previous week's rank
  • You would NOT want to have a portfolio consisting of all stocks in the same industry (red arrows)

If we have five stocks selected, do we buy an equal number of shares of each? That would work if the stocks sell for the same price. Then we would be investing equal amounts of cash in each security. However, we are generally purchasing equities of different market values. How then do we calculate how many shares to purchase and how many contracts to sell? Stated differently, how do we allocate our cash? Once determined we can then sell our covered calls.

Let's assume we have gone through the process of stock selection. The number of stocks to include in this month's portfolio would depend on the amount of cash we have to invest. Here is a guideline:

  • $50k or less = 5 to 6 stocks
  • $100k or less = 5-10 stocks
  • $250k or less = 10-15 stocks

Once we have ascertained the number of different stocks to include in our portfolios, every effort is made to invest a similar cash amount into each equity. In this article's hypothetical, we have nine stocks and $100k to invest:

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Cash Allocation Chart

Mathematics of cash allocation:

With nine stocks and $100k, we approximate $11k per stock. Next we divide the price per share into $11k and get the number of shares we can purchase. Since 1 options contract = 100 shares, we must round off to the nearest one hundred. If the number is near the middle as it is with FFIV, I will round up or down based on previous experience with that security or on the technical status of that equity.

Next I will multiply the number of rounded off shares by the price per share and calculate the total cost to purchase all shares. In the above chart, that comes to $96,780. I do this for two reasons. First I want to make sure that I can pay for all these shares and don't go over my $100k budget. Second, I want to be sure that I also have extra cash left over for possible exit strategy execution. In the above example, $3220 is the cash balance, quite adequate. We take this information together with the calculations computed by the Ellman Calculator and sit down in front of our computer and start generating cash!

Note also that with the exception of XEC, we sell more than one contract for each stock. That will allow us to "ladder" our strikes (use a combination of in-the-money and out-of-the-money strikes) if we so choose. In other words, for an equity like PAY we can sell three O-T-M strikes and two I-T-M strikes or some other combination depending on our market outlook. If we were extremely bullish on the market and stock technicals were impressive and confirming, we may opt for five out-of-the-money contracts.


When creating our covered call portfolio stock and industry diversification is critical as is cash allocation. This way, no one stock or industry will impact our portfolio in an extreme manner.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.