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Mastering Covered Call Writing: Learning From Your Mistakes by guest author Laurie Itkin

Sophia Loren once said, “It’s better to explore life and make mistakes than to play it safe. Mistakes are part of the dues one pays for a full life.”  I presume she was speaking about love and romance rather than options trading, but her advice is sage in both situations.

I follow Loren’s advice in my options trading.  I like to explore new strategies and understand that I can’t always play it 100% safe otherwise I might miss out on ways to make higher returns.   And yes – I do make mistakes.  Luckily, there are several rules when trading covered calls that can reduce the number of mistakes one makes.  Although women tend to make the same mistakes over and over again in relationships (at least that’s what the ladies’ magazines will tell you), in options trading making a mistake can be a valuable lesson which will make you a more successful and profitable trader.  And you don’t have to fall in the trap of making the same mistake twice.

The members-only area of The Blue Collar Investor (BCI) website contains a list of the ten most common mistakes of covered call writers.  I’m here to tell you that even experienced covered call writers make mistakes from time-to-time.   The mistake I made three months ago?  I wrote a covered call during a contract period where there was an upcoming earnings report. 

I had made a nice credit early in the year selling a call spread (buying and selling call options on the same stock with the same expiration but different strikes) as Netflix’ s (NFLX) share price was declining.  In late June, NFLX made a reversal and what appeared to be an uptrend began.  After looking at the chart and discovering that calls were selling at a juicy premium, I decided to write an at-the-money covered call on July 5.  I bought 200 shares of NFLX at $77.77 per share for a $15,554 debit and simultaneously sold two Aug 18 $77.75 calls for a $1,436 credit.  (Had I bothered to check that July 24 was the earnings date, I would have understood why the call premium was so high.)  Below is chart and as they say “a picture is worth 1000 words”

Avoid earnings reports when selling covered calls

NFLX gaps down after an earnings report

As you can see from the chart, on July 25 NFLX’s stock price plunged, and then continued to decline.  Unfortunately, the stock has continued to stay mostly range-bound (near $55 a share at the time I wrote this article), well below the $77.77 I paid for the shares!  In the case where the stock price plummets like this, even BCI’s recommended exit strategies for how to manage the call position will not take the painful sting out of this insect bite!   There is a silver lining to this story, however.  I took a relatively inexpensive kick in the gut which will remind me not to ever make this mistake again. 

The bottom line is unless you have a huge tolerance for high risk, do not sell calls during the contract period of earnings announcements. BCI’s stock screener rules out stocks that have upcoming earnings announcements which are chronicled as shown below:

Blue Collar Investor Premium Report

Earning Report dates in the BCI Premium Stock Reports

However, once you are in a position, before you roll the call into the following month, you must remember to check when the next earnings announcement is and consider closing your position.  And if you do make a mistake, remember what Loren said.

Laurie Itkin is Founder of The Options Lady (www.theoptionslady.com) and can be reached at theoptionslady@gmail.com.

(Laurie has agreed to write periodic articles on our BCI site about covered call writing from a woman’s perspective. We welcome Laurie to the BCI community-Alan) 

Chart of the week:

In our BCI methodology we have a strict series of fundamental, technical and common sense screens (one of which is avoiding earnings reports that Laurie alluded to above).  Below is a chart for AMGN, a stock currently on our premium running list, which depicts the bullish signals we look for when evaluating covered call candidates:

Covered call writing-technical analysis

 Premium members will note that our running list shows the following for AMGN:

  • Industry segment rank of “A”
  • Beta of 0.68
  • % Dividend Yield = 1.70

Once a stock meets our fundamental, technical and common sense screens, we check the calculations to see if it meets our financial goals.

 Market tone:

 This week’s economic reports leaned to the positive:

  • The unemployment rate for September dropped to 7.8%, the lowest since January, 2009
  • An unimpressive 114,000 new non-farm jobs were added while July and August new jobs stats were revised higher
  • The ISM manufacturing index rose to 51.5 in September, up 1.9 points from August (a reading > 50 indicates economic expansion). Experts expected a reading of 49.7
  • New manufacturing orders rose 5.2 points in September after 3 months of contraction
  • Construction spending was down 0.6% in August from July but up 6.5% from August, 2011
  • The ISM’s gauge for nonmanufacturing activity rose to 55.1 versus consensus of 53.5
  • In the September meeting minutes, the FOMC discussed purchasing an additional $40 billion of mortgage-backed securities/month to boost the sluggish economy

For the week, the S&P 500 rose by 1.4% for a year-to-date return of 18.1%, including dividends.

Summary:

IBD: Confirmed uptrend

BCI: My personal concern of a weaker earnings season tempers my short-term outlook to cautiously bullish, laddering ITM and OTM strikes about 50/50.

My best to one and all,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

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About laurie

Laurie Itkin is Founder of The Options Lady where she mentors individuals to become successful self-directed investors in the stock and options market.

9 Responses to “Mastering Covered Call Writing: Learning From Your Mistakes by guest author Laurie Itkin”

  1. Barry B October 7, 2012 1:28 am #

    Premium Members,

    The Weekly Report for 10-05-12 has been uploaded to the Premium Member website and is available for download.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the BCI YouTube Channel link is:

    http://www.youtube.com/user/BlueCollarInvestor

    Best,

    Barry and The BCI Team

  2. Chris October 7, 2012 3:51 am #

    Alan,

    Any help managing this position will be greatly appreciated. I bought ALGN for $37.25 and sold the $39 October call option for $1.10. This article reminded me to check the earnings date and sure enough I messed up as it reports on 10-18 the day for expiration. The stock closed Friday for $38.14 and the option bid-ask price is $1.65/$1.75. Thanks for your guidance.

    Chris

    • Alan Ellman October 7, 2012 12:29 pm #

      Chris,

      This is a common mistake made by many new to covered call writing. That is why it was a great topic for Laurie to articulate. Given the current stats you provided, your position can be closed with a credit:

      On the option side you will have a net debit of (-) $65 per contract ($1.10 – $1.75 x 100) and on the stock side a net credit per contract of + $89 ($38.14 – $37.25 x 100) for a net credit of $24 per contract exlusive of commissions.

      Although this is NOT part of the BCI methodology, if you have a strong belief in a positive report you can close the short position for a debit of $65/contract and hope to take advantage of a strong report.

      Alan

  3. Saul October 7, 2012 5:33 pm #

    On this weeks stock report there is a comment for EQM that the chart < 3 months. Is that an indication we should avoid this stock? thanks for your service.

    Saul

    • Barry B October 7, 2012 7:22 pm #

      Saul,

      From a conservative trading perspective, we like to see 6 months to a year of price history before including in our portfolios. However, some of The Blue Collar Investor subscribers have a higher risk profile, so I included EQM for those traders. Seeing how a stock performs over time can help you better manage your trades. When a stock shows less than 6 months of price history but other wise show strength, I place a comment in the comment box to that effect.

      So…if you are a more conservative investor, you might want to pass on a stock with less than 6 months of price history. If you are more aggressive, you should review the details of the stock to see if you want to include it in your portfolio.

      Best,

      Barry and The Blue Collar Team

      • Barry B October 7, 2012 7:52 pm #

        Saul,

        One other point, in most cases, stocks that have less than 6 months of price history.also won’t have a StockScouter rating.

        Best,

        Barry

        • Saul October 8, 2012 6:44 am #

          Barry,

          Thanks for the explanation. Keep up the good work.

          Saul

          • Alan Ellman October 8, 2012 6:55 am
            #

            Saul,

            The chart below of GNC (NOT currently on our running list) is an example of a recent IPO that previously earned its way onto our premium list in the past and did quite well for our higher risk tolerant members. For the more conservative investors, waiting for at least 6-months to 1-year of performance is a better comfort level. (Click on image to enlarge and use the back arrow to return to this blog):

            Alan

  4. Alan Ellman October 9, 2012 7:43 am #

    Running list stocks in the news: ALGN:

    Align Technology (medical devise maker) is due to report earnings on 10-17 and last reported on July 19th. Earnings increased by 70% year-to-year beating estimates by 21.4%. Revenues were up 21.2% year-to-year also beating estimates and company guidance. ALGN has delivered positive earnings surprises in the last 6 quarters with an average beat of 22.5%.

    Its core product is “Invisalign” (clear braces for adults) which I use in my dental practice. I can tell you first hand that it is a fabulous technology that works as advertised. ALGN is currently trading at a high PE of 31 compared to its peer group average of 20 but is justified due to its high growth rate of 18%. Our premium “running list” shows an industry segment rank of “B” and a beta of 1.57.

    Alan

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