A Seldom Mentioned Benefit of Covered Calls

This is a good time to trade covered calls. Well, most times are. When there is a clear upward bias in the market, when most stocks are participating, I switch to nearly all-option trades. True blue bull markets aren't that common. Most of the time, most stocks will cycle up and down within longer term trends, and this is good for covered calls.

There are traders, often those new to short-term trading, who are looking for one strategy or system that will generate 20% returns a month. Because it can take a while to find the right system(s) for an individual's comfort and risk level, and the fact no system works 100% of the time and there can be significant drawdowns, such trading should be used only to ‘juice' overall returns. Only a fraction of a short-term trading portfolio should be used for high risk trading.

Seasoned traders know the real secret to wealth accumulation is consistency – regular, relatively consistent profits that keep you in the game. Aside from the regular income or wealth accumulation that provides, it helps keep you in the market for when a rare position takes off for triple digit gains.

New traders should start off with trading stocks. Master the art of managing trades and, on average, achieving steady gains, before moving to more complicated or riskier strategies.

The next step would be to start selling calls against your stocks (‘Covered Calls'). This is actually considered lower risk than just buying stock because the income from selling calls lowers the cost basis of your stock, providing you with a buffer in case the stock pulls back a bit.

Covered calls don't interest some short-term traders because they have a reputation of returning ‘only' 2-3% a month. Of course, when they were saving up over the years to get to the point where they could invest or trade, they would have been quite happy with 2-3% returns a month. All of a sudden, with a new brokerage account opened and funded, 2-3% a month sounds paltry and not worthwhile.

What isn't often highlighted in articles on covered calls is by just being ‘in the game', you often end up in situations where the returns can jump significantly. It does require good trade management, although watching and managing covered call trades are much simpler than with other trade strategies. In most cases, all the required work can be done after market hours.

I have an example to show how good gains can be achieved with minimal trade management.

In the Monday, May 13th 2013 issue of the Seasonal Forecaster newsletter, I focused on a Chinese internet company (SINA), and how the stock had suddenly come to life. My investigations showed it had improving business prospects, ratings increases, and a chart that showed strong buying coming in – the kind of things all short-term traders should be looking for.

I strengthened the case for buying this stock by showing that SINA had a track record of an average 8.9% gain over the next four weeks. It is a growth company that often shows likely institutional accumulation in the summer heading into the fall.

I pointed out that at the time, SINA had rather high ‘Implied Volatilites', meaning its options were richly priced, which makes covered calls especially attractive. SINA was due to announce earnings in a few days. There were a few ways to trade this setup.

1) Enter a covered call now by buying the stock at the open and selling a May 60 Call against it, and letting the stock be called away if SINA closed above 60 on Friday, which was May options expiration.

2) Wait until after the earnings announcement on Thursday. On Friday's open, if the earnings announcement was good, consider entering a covered call based on the June options.

3) Buy the stock now, and sell a call against it turning it into a covered call at some time in the future, perhaps after the earnings announcement. This is a ‘delayed covered call', and can often work to produce even higher returns for covered calls.

Let's step through this trade, using the first approach.

On Monday morning, SINA opened up at 58.98, just a hair below Friday's close of 59.14. The May 60 call was selling at around 1.80. Since the option was ‘out-of-the-money', this was a pretty good premium with only 5 trading days left until expiration.

Buying 100 shares of the stock at 58.98 and selling a May 60 Call at 1.8 meant the cost basis, the net cost of the trade, was 57.18 (58.98 – 1.80), or $5,718.00 for buying 100 shares of stock and selling 1 May call.

In my newsletter, I suggested letting the stock be called away if the option expired in-the-money.  SINA closed on Friday at 59.57, so that was not an issue. The option expired and we would still be holding the stock. The earnings announcement was good and the stock showed strong buying on Friday, so it would make sense to hold on to the stock and consider selling a June call against it.

SINA opened up strongly on Monday morning (5/20), and closed near the day's high. It would make sense to wait for the first down-day before selling a call, to let the stock appreciate as much as possible first.

On Tuesday, SINA began pulling back after the open. Within 15 minutes SINA fell to 60.97. A June 60 call was going for $2.00. Selling a June 60 call for 2.0 would give us a total 3.80 (or $380) in income so far on this trade, and the cost basis would be lowered to 55.18. At this point, SINA could fall 9.5% before we would even start to lose money on the trade.

SINA consolidated for a month, and by June 21st, expiration of June options, SINA closed at 54.48. There was no danger of the stock being called away, and we were down just 1% on the trade. It would make sense to hold on to SINA and sell a July call against it early next week.

On Monday, June 24th, SINA, like the S&P 500 overall, opened lower but recovered later in the day. The next three days produced a decent rebound. On Friday, June 28th, SINA sold off right from the open. Around 15 minutes after the open, SINA was down to 55.70. The July 57.5 calls were going for around 1.22. Selling a July 57.5 call would bring in another $122 in income, and lower the cost basis on the stock to 53.96.

SINA meandered sideways for the next couple of weeks. Then on last Wednesday, July 17th, SINA logged a strong up-day:

The July options were due to expire in 2 days and the July 57.5's were in-the-money by 2.64. The position was in danger of being exercised, meaning the stock could be called away. Just prior to the close, or certainly at the next market open, it would have made sense to ‘roll-up-and-out' the July 57.5 calls into August 60 or 62.5 calls.

At 15 minutes before Wednesday's close, the July 57.5's were going for 2.70, and the August 62.5's were going for 2.35. Since the stock price was up 10% from the cost basis, it's ok to pay a slight debit to roll up and out to the August 62.5's. The cost basis is now 53.97 + 2.7 – 2.35 = 54.32.

By managing this trade over the past two months we kept ownership of the SINA stock, a good quality stock that was showing signs of institutional accumulation, and were in position to benefit from the sudden jump SINA took on Thursday, July 18th. All of a sudden, the stock is up almost 20% from our cost basis, 10 weeks into the trade. And during most of the trade, we had at least a 10% buffer on the downside to accommodate minor pullbacks.

This stock is still showing strength. In fact, if you look at a weekly chart, SINA may have formed a ‘saucer', or bowl-shaped long-term base.

SINA has potential for substantial gains from here. Because we were willing to accept a small, 2-3% monthly gain to start with, we found ourselves in a front-row seat, with a 10% discount, to a possible big move, the kind that makes you smile when you tally up results at year-end.

While I used intraday prices and trades in the above example, successful covered call trading can be done with most analysis and decisions made after market hours. You don't need to watch the market closely all day. Investigate if your brokerage offers email alerts to help you keep track of positions.

The SINA position needs to be monitored of course. The August 62.5's are in-the-money, although the time value is high enough where early exercise isn't likely. But as the August expiration approaches, if the stock is above the 62.5 strike price, another adjustment will be appropriate.

This is also a good add-to-the-position spot. Seasonal traders will regularly sell their weaker positions and buy more of the positions that are working.

Of course, there's much more you need to know and many more stocks you can capitalize upon each and every day.  To find out more, type in www.markettamer.com/seasonal-forecaster

By Gregg Harris, MarketTamer Chief Technical Strategist

Copyright (C) 2013 Stock & Options Training LLC

Unless indicated otherwise, at the time of this writing, the author has no positions in any of the above-mentioned securities.

Gregg Harris is the Chief Technical Strategist at MarketTamer.com with extensive experience in the financial sector.

Gregg started out as an Engineer and brings a rigorous thinking to his financial research. Gregg's passion for finance resulted in the creation of a real-time quote system and his work has been featured nationally in publications, such as the Investment Guide magazine.

As an avid researcher, Gregg concentrates on leveraging what institutional and big money players are doing to move the market and create seasonal trend patterns. Using custom research tools, Gregg identifies stocks that are optimal for stock and options traders to exploit these trends and find the tailwinds that can propel stocks to levels that are hidden to the average trader.

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