For those of you who are making too much money with covered calls, we have put together a list of ways that you can use to quickly give some back.
Or, heaven forbid, you have been losing money with covered calls... then you may want to scan this list and see if you are guilty of any of these sins. It's never too late to improve your investment strategy.
10. Don't Diversify
There's nothing like the adrenaline rush of betting it all (or most of it) on a single idea or trade. Great way to win big if it hits. But even if you're right once or twice and score big, a non-diversification bet-the-farm strategy will eventually come upon a trade that doesn't work and you will have a major draw down or get wiped out.
Try to have at least 10 non-correlated investments at all times. If you don't have the capital to buy 100 shares of 10 different stocks then look at ETFs instead of stocks because most ETFs are a basket of stocks and have therefore removed most single-stock risk. The broad-market ETFs (SPY, IWM, QQQ, DIA) or sector ETFs (XLY, XLP, XLE, XLF, XLV, XLI, XLB, XLK, XLU) are a reasonable place to start for smaller accounts seeking diversification.
9. Use Aggressive Position Sizes
Why buy 100 shares when you have just enough capital to buy 5,000 shares? In general, no position should be more than 10% of your portfolio. Some people like to start with 1/2 or 1/3rd of their normal position size so that if the stock falls they can buy more at a lower basis (assuming the reasons for the drop haven't eliminated their thesis for owning the stock in the first place). There's nothing wrong with having cash on hand so you can add to existing positions on dips.
8. Ignore Earnings Dates
If the underlying stock is part of your core long-term holdings then, yes, you can mostly ignore earnings dates because you plan to hold the position across several reporting cycles. But for the short-term buy-write investor who plans on holding the stock until option expiration, you really need to be aware if there is an earnings release prior to expiration.
You'll usually know this because the premiums will be much higher for an option with an expiration date after the earnings date compared to an option with an expiration date before the earnings date. Best to stay away from high volatility events like earnings releases if you're not planning on owning the stock for the long term.
7. Buy Biotechs And Pharmaceuticals Subject To FDA Announcements
Similar to earnings release dates, FDA announcements have the ability to significantly move a stock's price. If you're going to gamble on a company's new drug or cure for cancer then covered calls are probably not the right strategy. If the drug or cure doesn't work or is denied by the FDA then the stock will most likely drop dramatically, and often times below your net debit break-even price (even if you sell in the money calls). And if the drug/cure works and the stock takes off, a covered call will cap your upside (not good -- if you took the risk you will want all the upside).
6. Buy M&A Rumors
Stocks tend to rise when there are rumors of buyouts. Option premiums rise, too, as investors prepare for a sudden 20% jump when a rumored deal is finally announced. Like other high volatility events, if this one doesn't come to pass then the stock could drop to below its pre-rumor price as disappointed investors dump the stock. Don't trade rumors.
5. Buy Momentum Stocks
Everyone likes a good story stock. From 2009 to mid-2011 Netflix was going to take over the world as the source of all entertainment content, and the stock went from $32 to $295. But then there was the crash in the 2nd half of 2011 as it dropped down to $64.
No amount of call writing can protect you from a 231 point drop in 5 months. NFLX was clearly a momentum/story stock at that time. Maybe okay to buy some shares if you have an exit plan with a fairly tight stop loss order in place, but covered calls are not the right strategy for that situation. Looking back, no one knew when the momentum train would stop but everyone knew that eventually it would. Better to stick with solid, long-term stocks that are less story-of-the-day.
4. Buy Leveraged ETFs
While some ETFs are good for conservative portfolios and can lower volatility through diversification, other ETFs should be avoided at all costs for covered call writing. Those would be the 2x and 3x leveraged ETFs. These instruments are meant for day traders seeking extra leverage on an ultra short-term (usually 1 day) bet. They are not to be held for weeks or months for covered call investing.
3. Use Lots Of Margin
With margin interest rates so low it can be tempting to borrow lots of money from your broker and then do a bunch of in the money buy-writes with it. There are times when that can be a winning strategy. But many other times the use of margin will simply amplify your losses and lead to a quicker ruin.
An investor has to be extremely disciplined when investing with borrowed money. Only the most stable, blue-chip, dividend-paying stocks should be purchased, and even then you should write in the money calls with your only goal to generate a return higher than the borrowing cost. Leave yourself lots of room for downside protection in case a bear market, or 10% correction, or adverse news for the underlying stock comes around before your stock (that was purchased with borrowed money) is called away.
2. Trade Thinly Traded Issues
Thinly traded issues have at least one major flaw: The bid-ask spread is so wide that it is prohibitively expensive to make adjustments to the trade after it's been put on. If you are writing deep in the money calls on thinly traded issues and are happy having them called away at expiration then maybe you can invest in these stocks. But because they are thinly traded they can be quite volatile, in addition to having wide spreads. Better to stick with option series that have 1000 or more contracts (i.e. open interest), and stocks that trade 500,000 shares or more per day.
1. Sell Fat Premiums Without Knowing Why They're Fat
The quickest way to lose a lot of money with covered calls is to use a screener to identify fat premiums and then blindly start doing buy-writes without having first done any homework to find out why the premiums are so fat.
Reasons for fat premiums can include: earnings, M&A rumors, pending FDA announcements, anticipated new product announcements, a related company's earnings or announcements, pending litigation, etc.
Before investing, go to a couple of your favorite financial news sites and enter the stock symbol. Then read the last couple of months of news to see what's going on with that company in order to figure out why the premiums are so high. If you can't find a reason then post a question on one of the stock trading forums. Someone will know. Don't invest until you know, and then decide if the risk/reward matches your investment plan. For volatile situations, keep positions extra small. Better to have a small gain or loss and live to fight another day than to get wiped out in one or two large bets that go wrong.
Summary Of How NOT To Lose Money With Covered Calls
Risk management is the key to long term investing and survival. It's true in covered calls, and it's true in every other investment strategy, too.
If you'd like to read 3 interviews with professional money managers who use covered calls full time, check out the Capital Wealth Planning Interview, Coastwise Captial Group Interview, and Van Hulzen Interview.