24 Oct 09 Covered Call - Play With House’s Money

Great Gamblers actually have a lot in common with great investors. They know excellent money management is the key to success. Their view is that as long as their money is on the table, it belongs to the game. Their Goal is often to get their own money off the table quickly, so they can play with the house’s money. In the investment world, a Covered call trading strategy is a good way to play with the house’s money. However, there are many different viewpoints. One is that you just find a good stock, and then if it trades options to just sell calls against it until the stock pays for itself. However this is a very limited viewpoint that doesn’t explain what a “good stock” is.

If you are typically a growth and momentum investor, you are generally relying on accelerating earnings and sales growth and price momentum and buying momentum to take over as the stock is bid higher. If you identify a good buy point this will NOT make a good covered call strategy.

The reason is, the premium on the option is generally based on recent volatility, and stocks that set up for a buy point typically consolidate as buyers take profit, sellers try to battle this stock back and buyers and sellers reach a stand still, then buyers gain momentum, and soon right near the buy point the buyers begin to take control. Sometimes the sellers will give-up, and cover their shorts, and the buyers will come in full force. This means that right before the buy point the stock’s premium is fairly low, and it’s not until after the stock breaks out that the price of the premium will be reflected based upon this volatility. In addition, this strategy is generally based on price appreciation. If you sell options on these stocks, you will limit your gain, and you will most likely not increase your potential very much. Generally the best strategy would be to sell out of the money options at your price target. However, generally this will net you a very small amount unless you are buying a lot of shares, and your fees per trade and per contract are very low. Even then, this is just adding a very small premium onto your shares, and usually isnt worth it as much. Instead, you may be better off learning to BUY options if this is your strategy.

On the other hand, If someone is not a momentum trader, and is going to buy stock s perhaps that just received upwards earning guidance, or if they have a strategy where they expect mild price appreciation, or if theyre just index investors, then perhaps a covered call strategy would work well. If you expect a mild price appreciation, you can sell out of the money options, and still gain from price appreciation up to the strike price, while also collecting a premium. Say you Identify a stock that is starting an upward or sideways channel, You are following a trend, you would want to identify the peak of that trend at expiration, and sell a call option near that strike price. This will allow you to adjust price targets, receive the capital appreciation gains, and also collect a premium.

Now generally covered call strategies are better for value investors, or even contrarian investors. You want a stock that you can own for a very long time, but is one that you dont anticipate any short term price appreciation. You can just collect premiums by selling at the money call options, or if you expect the stock to actually decline slightly at the moment, you can sell in the money options, hoping that the stock declines out of the money, and that you dont have to be assigned on your call. This way you can own the call and write another call option month to month, collecting income.

There are other strategies such as just collecting the maximum premiums that are available. This may be a bit dangerous since these are stocks that people expect to make big moves, and those moves arent always up. The price of a call and put are directly correlated, so just because a covered call will yield you a high percentage yield, doesnt mean it is worth it. It is generally associated with higher risks, and most likely, if the stock does go up, it will be a big move, you will be limited in only being able to collect the premium, and you could potentially lose everything if the stock tanks to zero. However, if you do enough research, seeking some of the top yielding covered call options is a good strategy, that can sometimes have you yielding around 10% a month. In addition, you may decide to use this to find stocks that are ready to move, and just buy the stock outright, avoiding additional costs associated with the option (such as the time premium and extra brokerage fees), and still allowing you to profit from the gains. Or perhaps you want to identify the stock and just buy out of the money calls.

Ultimately its up to you to pick a strategy you understand, and learn as much as you can, taking whatever courses you need to and educating yourself so that you are prepared to make money in a way that works for you.

Maclin Vestor teaches about varioustrading systems and teaches you to find a trading system that works for you.

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