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Myths and Misunderstandings About Covered Call Writing

Covered call writing education must include debunking the myths associated with this strategy. When certain concepts are repeated often enough, they become accepted as truths whether they are accurate or false. The purpose of this article is to refute five of the most egregious of these misrepresentations.

 

1. Covered call writing should be used in flat markets only

Truth: This strategy can be crafted to succeed in all market conditions. We accomplish this by selecting the most appropriate underlyings in bull (more volatile) and bear (less volatile) markets and the best options in bull (out-of-the-money) and bear (in-the-money) markets. We are also prepared with our bull/bear exit strategies.

 

2. We should focus in on stocks and options that generate the highest returns

Truth: Option premium is directly related to the implied volatility (IV) of the stock or exchange-traded fund (ETF). Covered call writing is a conservative strategy with capital preservation a key requirement. By selecting high-IV stocks, we are converting the strategy to a risky one. Instead, set up an initial time-value return goal range that will manage the risk we are subjected to (2% – 4% in my case).

 

3. 90% of all options expire worthless

Truth: 10% of options are exercised but the other 90% includes 55% that are closed and 35% that expire worthless as shown in this chart:

 

4. We are forced to sell winners and retain losers

Truth: When we sell a covered call, we are accepting an obligation to sell the stock. However, that commitment can be cancelled by closing the short call or rolling the option. Mastering the exit strategy skill will leave us in control. The same holds true for under-performing stocks. We can first buy-to-close the short call and then sell the stock. As we manage our positions, our portfolio will consist of elite-performers that generate initial time-value premiums that meet our conservative goals.

 

5. Sell options prior to an earnings report to generate the highest returns

Truth: NEVER sell an option prior to an earnings release. There is too much risk associated with a disappointing report. Allow the report to pass and then write the call if the underlying meets our system requirements. Covered call writing is a conservative strategy where we can generate dependable modest returns that will beat the market on a consistent basis. Risk is to be avoided, not embraced.

 

Discussion

A critical component to our financial education is to debunk the long-standing myths pervasive in our society. By mastering the 3-required skills (stock selection, option selection and position management), we will unmask the truths of covered call writing and create opportunities to achieve the highest possible returns as we beat the market on a consistent basis.

 

Your generous testimonials

Over the years, the BCI community has been incredibly gracious by sending our BCI team email testimonials sharing stories as to what our educational content has meant to their families. Moving forward, we have decided to share some of these testimonials in our blog articles. We will never use a last name unless given permission:

Hi Alan,

Just a quick note to say that you did a Great Job as always during your Money Show presentation last week. I so appreciate your down to earth, stable advice that you always give– backed up with actual examples.

Thanks,

Tracy

 

Upcoming events

 

1. Michigan AAII Chapter webinar

Trading in a Low Interest-Rate Environment

Creating a 3-income stream strategy

Wednesday June 24th

7 PM

Login information to be sent to registered members (club and premium members)

 

2. Greensboro North Carolina AAII Chapter webinar

Covered Call Writing to Generate Monthly Cash-Flow

Option Basics and Practical Application

Saturday June 20, 2020

10 AM

Login information to be sent to registered members (club and premium members)

This presentation will include the basics of trading option, an overview of covered call writing and 4 practical applications of the strategy.

 

Alan speaking at a Money Show event

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Market tone data is now located on page 1 of our premium member stock reports and page 8 of our mid-week ETF reports.

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

20 Responses to “Myths and Misunderstandings About Covered Call Writing”

  1. Naveen May 23, 2020 3:43 am #

    Alan,

    Thank you sir for the articles. They were helpful a lot. Just one more help from you.

    How does options implied volatility relate to the stock or indexes overall volatility. While buying options or selling options should we see the volatility of the stock/index in which we are trading or we should see the volatility of the option strike price we are planning to trade.

    Please help me on this .

    Thank you.

    Regards,

    Naveen

    • Alan Ellman May 23, 2020 6:37 am #

      Naveen,

      This is an outstanding question.

      Understanding Implied volatility(IV) is critical to our overall success.

      Option premium is directly related to the IV of the underlying stock/ETF. The appropriate IV will vary from investor-to-investor based on strategy goals and personal risk-tolerance. The good news is that we do not have to look up the IV for every security we are analyzing. Here’s how we incorporate IV into our trading decisions in our BCI methodology:

      We first establish an initial time-value return goal range. The higher the range, the greater the risk and vice-versa. For me, it’s 2% – 4% for Monthly contracts. The IV of the stock/ETF is “baked into” the initial % return. For those with higher goals and greater personal risk-tolerance, that range will be higher. For those with more conservative goals, the range may be lower (I use 1% – 2% in my mother’s more conservative portfolio).

      1. Develop a watch list of eligible stocks/ETFs (we do this for premium members)

      2. Determine the “moneyness” of the options (in-the-money, at-the-money, out-of-the-money)

      3. Check the option-chain for strikes that meet the predefined initial time-value return goal range. Those criteria will lead us directly to the most appropriate strikes to select. Implied volatility is very much part of the decision without actually looking up the IV for each position being considered.

      Alan

  2. Thor May 23, 2020 9:25 am #

    I would like to suggest that you add an EFT to your list.

    The ticker symbol is PNQI and it tracks the NASDAQ Internet IndexSM.

    I think it will continue to outperform the S&P even after the pandemic has passed, because it does not include all the business segments like leisure and travel that will probably take years to come back.

    Thank you

    Thor

    • Hoyt T May 23, 2020 4:38 pm #

      Hi Thor,

      Alan can answer you far better than I and I am certainly not speaking for him.

      I am checking in on Saturday afternoon. I trade on E*Trade. I couldn’t see any open interest on options for PNQI. Unless something is wrong with my trading platform, and that is possible, you can’t trade options on PNQI because there is no open interest and no volume. You can trade the ETF itself but you can’t do any Covered Call writing under the BCI methodology.

      I may be missing something and I probably am. If so, please accept my apologies.

      Hoyt T

      • Roni May 24, 2020 4:54 pm #

        Dear Hoyt

        I read your post to me in last week’s thread, and thank you very much for your preocupation.

        Yes, we are fine, but yes, Brazil is in deep trouble.

        Several friends and aquaintances have been contaminated, some have passed away and some have recovered with enourmous sufferings.

        More than 40 million families live in very precarious housing, and impossible to confine conditions. Also, they have no savings, and cannot survive without daily income.
        The government is paying them a small monthly ammount to help.

        Private solidarity is very strong and active with food distribution, at enourmous risk.
        Brazilians are very kind and charitable.

        We hope the desease will subside soon.

        Roni

    • Barry B May 23, 2020 5:00 pm #

      Hi Thor,

      As Hoyt did, I checked PNQI on Schwab (using StreetSsmartEdge) and found that there is zero open interest…although the ETF is listed as having options. However, you might consider these other ETFs that have a similar industry/segment exposure but with significant open interest. The performance numbers are over the last 200 days:

      PNQI: +18.69%
      QQQ: +22.78%
      XLK: +22.95% (On this week’s ETF report)

      Best,

      Barry

  3. Barry B May 23, 2020 9:11 pm #

    Premium Members,

    This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor Premium Member site and is available for download in the “Reports” section. Look for the report dated 05/22/20-RevA.

    We have made two improvements to thew report this week. Specifically:
    – Improved the $SPX and $VIX chart a bit more useful
    – We have improved the visibility of the stock reporting earnings
    in the next week

    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 link to the BCI YouTube Channel is:

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

    Since we are in Earnings Season, be sure to read Alan’s article, “Constructing Your Covered Call Portfolio During Earnings Season”. You can access it at:

    https://www.thebluecollarinvestor.com/constructing-your-covered-call-portfolio-during-earnings-season/

    Best,

    Barry and The Blue Collar Investor Team

    [email protected]

  4. Roni May 24, 2020 4:13 pm #

    Alan,

    regarding “4. We are forced to sell winners and retain losers”

    My feeling is : When I am forced to sell a winner, I am the winner.

    And when I have chosen a loser, I can decide the best alternative from the exit strategies learned at the BCI school.

    Roni

    • Alan Ellman May 25, 2020 9:03 am #

      Thank you, Roni. Very well stated.

      Alan

  5. Marcus May 25, 2020 6:00 am #

    Alan,

    Please tell me what fundamentals you look at and what ranges you use.

    For example, if you use PEG, do you focus on companies below a certain PEG or PEGY?

    Thank you.
    Marcus

    • Alan Ellman May 25, 2020 9:13 am #

      Marcus,

      Let me respond in 2 ways:

      1. For our premium members, stocks are screened via fundamental, technical and common-sense requirements. We use several IBD screens among other screens including MAR (mean analyst ratings).From there, we screen using our technical and common-sense parameters. These screens are geared specifically for short-term option-selling.

      2. For those who are not members, there are several free online screens that are for stock selection, not option-selling but serve as a starting point for option-selling. I’ve attached a screenshot taken from my book, “Stock Investing for Students” showing a sample screen.

      CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.

      Alan

  6. Larry May 25, 2020 11:23 am #

    Alan,

    My name is Larry from Kansas City, a premium members, and I was watching your podcast 8: covered call writing risk reduction.

    What do you think about this trade idea?

    Stock: PAYC
    Buy 100 shares at $269.35
    Sell 6-19-20 Call @ 250 strike for 27.15
    Buy 6-19-20 Put @ 220 strike for 2.38

    I understand, I’m using weekend prices. But as a general idea, what happens on the downside?

    Thanks, Larry

    • Alan Ellman May 25, 2020 3:32 pm #

      Larry,

      Using both deep ITM calls and deep OTM puts may be overkill while still having significant risk exposure.

      The breakeven for the ITM call is $242.00 and the put protection begins at $220.00 so no protection between those 2 numbers.

      The typical collar is constructed with an OTM call and an OTM put that results in an initial time-value return goal range that meets our stated goals in regards to returns and protection..

      The BCI Collar Calculator is particularly useful for these calculations.

      Alan

  7. Lisa May 26, 2020 11:10 am #

    Good morning Alan

    Do you use any hedge for your options?

    For puts, do you use credit put spread, i.e. buying a further “out-of-the-money” put could limit the downside risk. There are all kinds strategies out there – straddle, iron condor, etc. Do you employ these?

    Thanks for publishing your stock screen watchlist. Are the stocks on the list is for writing calls only?

    Thanks,
    Lisa

    • Alan Ellman May 27, 2020 5:32 am #

      Lisa,

      My responses:

      1. There are several ways we can hedge our positions. Some include protective puts, deep ITM calls, deep OTM puts, using low-volatility stocks and ETFs.

      2. Over the years, I have tested most option strategies and have my greatest success with covered call writing and selling cash-secured puts. That’s where I’m at today. This doesn’t mean that an investor can’t realize success with other, more sophisticated strategies, but I’m happy to share my experiences with our BCI community.

      3. The stocks on our premium watch lists are eligible for all option strategies. They are elite-performers from fundamental, technical and common-sense perspectives.

      Alan

  8. Angie May 27, 2020 12:36 pm #

    Hi Alan –

    Hope you’re staying safe and somewhat sane in this crazy world and stock market!

    I was hoping you might be able to do an “Ask Alan” segment (or point me to one you already did) on setting up the “next” trade in a PMCC after the short expires or hits the 20%/10% buy back an executes.

    I’m paper trading PG and the short call hit the 20% rule and executed on Monday. In setting up the next trade, I’m using the initial trade tab and my question is do you keep all these parameters the same:

    -Initial stock price (or do you update to the day you’re doing the trade?)

    Leap strike wouldn’t change

    Leap ask price – I’m assuming you would leave this at the price you originally paid, yes?

    So then you just manipulate the short call to fulfill all the other parameters.

    Where I’m stuck is that the original TV of the leap was $1.72 but it’s up to $1.91 right now… should I be shooting to cover the current time value of the leap with the short call, whether that is higher or lower than the original TV?

    I’m sorry if these are silly questions… I know it’s easy to go wrong quickly in leaps so I want to be sure I’m understanding before I put real money in!

    Thanks so much!
    Angie

    • Alan Ellman May 27, 2020 3:50 pm #

      Angie,

      This is a good idea for an “Ask Alan” video. Thank you for the suggestion.

      For now, after executing the 20% BTC order, move on to the tab to the right of the initial trade tab, titled “TM (trade management)-Short Call- Current Month. This should give clarity to the choices.

      See the screenshot below.

      CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.

      Alan

  9. Alan Ellman May 27, 2020 5:37 pm #

    Premium members:

    This week’s 8-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site. The report also lists Top-performing ETFs with Weekly options as well as the implied volatility of all eligible candidates.

    Also included is the mid-week market tone at the end of the report.

    For your convenience, here is the link to login to the premium site:

    https://www.thebluecollarinvestor.com/member/login.php

    NOT A PREMIUM MEMBER? Check out this link:

    https://www.thebluecollarinvestor.com/membership.shtml

    Alan and the BCI team

  10. Charles May 29, 2020 12:55 am #

    Alan,

    Today I was doing BTC on some options I had as stock values
    dropped. I was still ahead on my profit from selling the calls.

    And, then I flipped them again!

    Charles

  11. Alan Ellman May 29, 2020 7:26 am #

    Outstanding work, Charles. Mastering the position management skill is one of the techniques that will set us apart from other option-sellers.

    Alan

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