How to Trade Options: Covered Calls

Covered calls are a conservative option trade that typically outperforms standard stock trading strategies in the majority of markets. The reason is because covered calls draw out profits from speculators while collecting a premium on the trade and holding onto the stock for dividends. Since you have multiple sources of profit in the trade, you have the opportunity to make money when the stock goes up, down or sideways.

For those who don’t already know, writing a covered call involves buying 100 shares of stock and then selling the call option on those 100 shares 1 or 2 strikes out of the money in the front month. This lowers your initial investment in order to own the stock and gives you multiple sources of profit.

Covered calls are an options trade best played on equities that are mild to moderately bullish in nature. A covered call outperforms standard stock trading strategies only when the market is mildly bullish or neutral. When the market rallies, writing covered calls will dramatically cut into your profit margins because you will get exercised against and be forced to sell your shares at a smaller than possible profit.

Here are some of the things I look for in writing a covered call:

1. 3-5% ROI from the premium. Assuming the stock doesn’t change in price during the trade, you should have made 3-5% of the value of the stock on the money gathered in the premium. Aim too high and you risk a lot. Aim too low and you’re hardly making any money.

If your profit margin is too high, it’s a sign that there is a great deal of speculation and volatility associated with this particular stock. You do not want to be buying a covered call on a stock that has a 6-10% ROI from the premium each month. The reason is because you risk things like catastrophic gapping from sudden news announcements or dramatic bullish breakouts that cut into your profit margins upon being exercised. Avoid this and play it safe with a smaller monthly ROI.

2. A stock should be trading above its 200 day exponential moving average for at least a month. Typically the 200 day EMA is the benchmark of whether an asset for an options trade is in an uptrend or a downtrend. Look to this as your primary technical indicator when determining a stock to write covered calls on.

3. A stock should have a Price to Earnings Ratios between 15 and 25. The price to earnings ratio measures a company’s earnings versus the value of each share of stock in the company. It’s an indicator of how valuable a company is, the lower the number, the better the earnings per share and the more profitable and growth oriented a company is. The higher the number, worse the earnings are per share and the more overvalued a company is. Companies with P/E Ratios above 30 are usually the result of mass speculation without much earnings to show for it.

You should expect a company to be moderately to well valued to place a covered call on it, so don’t look for the undervalued companies ready to explode or the overvalued companies preparing to crash. Try to stick somewhere in between.

4. A stock should have a relative strength index between 45 and 70. Relative strength is the measurement of the overall amount of upswings in price action versus the overall amount of downswings averaged out over a period of time. When the average number rises above 70, the position is considered overbought and values below 30 are considered oversold.

I recommend staying in between 45 and 70 to make sure you are dealing with a stock that has a positive outlook, but isn’t going to explode off the chart any time soon. This will help make sure your options trade isn’t getting cut out of profits by being exercised and is still performing well without losing equity in the market.

Article Source: http://www.moneyarticlelibrary.com

www.tamingthemarkets.com

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