Last update: July 2021
The tinker temptation is often undeniable for traders. It’s an itch to squeeze just a wee bit more alpha out of your strategy that just never goes away. No matter your trading approach the question of, “how can I make it better?” is always circling that big old brain of yours.
The ultimate objective is to craft a set of rules, a master plan, which effectively maximizes gains while minimizing losses in both turbulent and calm seas. Even those who have long since optimized their strategy still feel the tinkering itch beckoning.
Side Note: Alternate titles for today’s article are “Behold, Covered Call Perfection” and “The Quest for Covered Call Perfection.” I just couldn’t pass up the picture of the cute little mouse seconds away from getting whacked. Don’t worry though. All mice go to heaven.
Covered calls have commanded my attention off and on over the past few months (see here, here, here, and here) and I’ve discovered a few tricks to improve the returns delivered by the income generator.
And what better way to test my comprehension, not to mention signal to Karma that I’m a good little soul willing to share my findings with the masses than to divulge the details in all their glory to you?
Remember, the covered call (aka buy-write, covered write, synthetic short put) consists of buying 100 shares of stock and selling a call option to score both income and downside protection. If you own an ETF like the SPY and are selling monthly covered calls then the only question you really obsess over is strike price selection. Selling lower strike calls affords more income, more protection, but less potential profit (you quickly cut off your upside in the stock). Selling higher strike calls, say, 2% OTM, affords less income, less protection, but more potential profit since you can participate in more upside in the stock before having to part with your shares.
Most traders selling calls on a monthly basis will choose which approach appeals to them at the outset and then continue to sell the same strike price month after month. It’s systematic, consistent, and delivers the goodies as promised.
For example, in my intro trade lab we purchased the Nasdaq-100 ETF (QQQ) last April and have been selling slightly OTM calls every month. And, as promised, the covered call has indeed delivered superior risk-adjusted returns. We’re up 3.8% while those who have simply bought and held QQQ are down 3.5%.
That right there is what the highfalutin traders like to call 730 basis points of outperformance. Alpha achieved!
But what if adopting a more adaptive approach could yield better results? What if instead of selling the same strike every month, we modified the threshold depending on our directional bias? When more bullish we could sell 2% OTM calls, when neutral to bearish sell ATM calls.
The data for buying the S&P 500 and selling monthly ATM calls versus selling 2% OTM calls is already available. I referenced the CBOE S&P 500 BuyWrite Index (BXM) in my initial newsletter heralding the merits of the covered call (see here). Remember, BXM sells the first call with a strike above the current SPX price level. It’s basically the ATM option. Here is the performance of BXM (gray) over the past five years versus straight buying SPX (yellow):
Due to the multi-year bull market carrying stocks to the moon BXM has underperformed buy and hold by a wide margin. Such is the fate awaiting all covered call sellers during a running of the bulls.
Or is it?
What if we had sold OTM calls instead? For that, I introduce you to the CBOE S&P 500 2% OTM BuyWrite Index (BXY). As the name suggests it systematically sells calls 2% OTM monthly. And, as mentioned previously, writing OTM covered calls provides less income and protection, but more participation in the upside during bull markets. So, for example, with SPY perched at $191, we would sell the 194 strike call (191 x 1.02). That allows us to score $3 on the stock before the upside is capped. Here’s the performance of BXY (gray) versus long SPX (yellow):
BXY did a much better job keeping pace. And since the SPX tends to climb over time a side-by-side comparison of BXY vs. BXM reveals the superiority of selling 2% OTM calls.
Some may say the takeaway then is for traders to always take the BXY route. But see, I want a better mousetrap. And selling ATM calls is superior in neutral to bearish markets. That’s when BXM shines.
So here’s the idea. Adopt an adaptive approach in your covered call selling routine by shorting OTM options when bullish but ATM when neutral to bearish. You don’t have to stick with 2% OTM though. You might consider a 30 delta or some other metric in trying to select the optimal strike when venturing OTM.
The trick is knowing when to switch. Might there be an easy line in the sand we can use to dictate whether we’re in bull or bear mode?
Of course.
How about a moving average? We’ll want to use a longer-term measurement to minimize whipsaw and jive with the long-term time frame that’s consistent with selling covered calls month after month. The 200-day moving average comes to mind. When the SPY is perched above that we’re probably in a long-term uptrend suggesting selling an OTM call is the better route. When SPY falls below the 200-day moving average we could shift tactics and sell the ATM call.
Assuming we don’t get whipsawed too much the BXM/BXY combo should deliver better risk-adjusted returns than one or the other in isolation. Indeed the wisdom of the strategy is borne out by the efficacy of the 200-day moving average as our indicator over the past decade.
In the first graphic, we have the four episodes experienced over the 2009-2015 bull market where the SPY slipped below the 200-day moving average (red boxes). In these instances, we would have shifted to selling ATM-covered calls. Once the SPY remounted the 200 MA we would have reverted back to selling OTM. The lion’s share of the time we would have been following the BXY path with OTM options thereby participating in the bulk of the bull market.
But what about bear markets? Might there be too much whipsaw to justify switching tactics from short OTM to short ATM calls?
Nope. At least not during the past two bear markets.
Matter of fact it was smooth sailing during the 2008 meltdown as well as the 2001-2003 bear (shown below). The SPY remained below the 200-day moving average the entire time giving you a clear signal to continue selling ATM calls thereby scoring extra income.
With the SPY now soundly below its 200-day moving averages proponents of this tactical approach would look to sell ATM calls for the time being.
Of course, past performance is not indicative of future blah blah blah. Maybe the current bear market will be whipsaw city, rapidly ratcheting above and falling below the 200-day like a jittery drug addict in need of a fix. But, whatever, I mean eventually the SPY will make up its mind and start trending one way or the other. And at that point focusing on selling 2% OTM calls (in the case of an upside resolution) or ATM calls (downside resolution) will generate better returns.
If nothing else having a methodology for optimal strike price selection will keep you entertained. Selling covered calls is semi-boring. Granted it’s less boring than buy and hold, but boring nonetheless. Admittedly, good investing is supposed to be boring so maybe that’s a good thing.
But, hey, if you want to spice things up a bit and give yourself something to do. Switching up strikes based on market conditions may be just the ticket. Even though I used SPY in today’s examples, the QQQ, IWM or any other major index ETF would probably have generated similar outcomes.
Tackle Trading Resources on Covered Calls
Continue learning about this powerful options trading strategy: the Covered Call. Tackle Trading has all the resources you need to MASTER this strategy like a PRO.
Covered Call For Beginners [Free Articles]
Learn How to Repair a Covered Call Gone Bad!
Join Coach D for an in depth look at a dynamic Covered Call repair strategy on $GMCR.
Options 101: How to set Basic Stops on Naked Puts and Covered Calls
In this video tutorial, Coach T walks the team through how to set a basic stop on a covered call or naked put position.
Options 101: How to find the perfect Covered Call Candidate
In this video tutorial, Coach T from Tackle Trading walks through a research session for covered calls.
How to use the Theta Research Tool to find the best stocks for Cash Flow
In this video tutorial, Coach Matt goes through the latest edition of the Options Research Spreadsheet explaining how to use it to find the best stocks to cash flow.
Options 101: How to Add a Protective Put to A Covered Call
In this video, Tackle Trading’s Coach Tim explains when, how, and why a trader would buy a put option on a covered call position.
Tales of a Technician: The USO Covered Call Nerve Strike
I seem to have struck a nerve with my call for a reverse split in USO. And that’s a good thing.
Video Tutorial: How to Repair a Covered Call to Reduce Risk
Watch and learn as Coach D demonstrates how to roll a covered call down and out to offset risk and bring in more premium as he repairs a protective call write that has traded below the strike price and break-even price point.
Tales of a Technician: Theta and Covered Call Management
Just when I think I’ve exhausted my inventory of covered call insights I stumble upon yet another blog worthy concept. Today I’ll shine a light on how to identify the remaining profit in your trade, an essential skill for covered call management.
Tales of a Technician: Covered Calls: Weekly vs. Monthly
With the advent of weeklys options the choices facing option traders has multiplied ten-fold. But it shouldn’t be overwhelming.
How to Pick a Good Covered Call
In this article we will breakdown the philosophy, construction, and management of the Covered Call cash flow strategy.
Tales of a Technician: Your Covered Call Questions … Answered!
Listen up you covered call lovers. Today I’m tackling some common questions on how to get the most out of your beloved buy-writes.
Trade Journal Series: How to use the Theta Research to find Covered Call candidates
In this video tutorial, Coach Tim Justice teaches how to find the best candidates to trade the Covered Call options strategy using the Theta Research tool.
Tales of a Technician: Covered Call Alternatives for IRAs
How to leverage an IRA account by selling covered calls on long-term call options (aka LEAPS) instead of stock? Read on.
Options Theory: Collaring Earnings
Earnings season is upon us. Whether it’s a straight stock position, you’re holding for the long run, or one that you’re selling covered calls on there is a straightforward way to limit your risk.It’s called a collar.
Options Theory: What a Covered Call Trader REALLY Wants
I think I could write about covered calls and naked puts every single week and still have plenty to say at the end of the year.
Options Theory: Picking the Right Stock for Covered Calls
I received an email the other day from a trader that bought a few stocks and has been selling covered calls against them. He had questions. I have answers. Here we go.
Options Theory: Combating Volatility with Covered Calls
Nothing like a monster “V” shaped reversal to get the juices flowing, am I right? Count me among those suffering whiplash over the market’s death-defying whoops and whirls of late. Yesterday was particularly annoying for those short delta toting traders like me.
Tackle Today: Do you trade Covered Calls?
Last update: August 2021 ≈ Cash Flow and Growth ≈ I put a poll question in the clubhouse recently asking the Tackle Trading community a simple question: Do you trade Covered Calls? If you haven’t answered the question yet, you still can HERE. Of the 5 potential answers, the breakdown was interesting. 38% said YES
Tales of a Technician: When Covered Calls Move In-The-Money
Traders have all sorts of rules and guidelines for managing covered calls that move in-the-money.
Tackle Today: Meet the Covered Call
The Covered Call strategy is an old friend of Tackle Trading. This strategy is so cool that we can talk about it every single day and still come up with new ideas.
Tackle Today: Covered Calls for Cash Flow
One of the most popular techniques in the equity and options market is the Covered Call. A Covered Call involves the purchase of at least 100 shares of stock and then the sale of 1 call option against that stock.
Options Theory: Tips for Buying Puts with Covered Calls
Let’s talk about proper strike price selection for covered calls and protective puts.
Portfolio Protection For Beginners [Free Articles]
Long Put: IWM or RUT
In this video tutorial, Coach Matt walks thru how he has been handling the additional macro risk in the market by trading Long Put options on the IWM.
How to add Insurance to your Portfolio
In this video tutorial, Coach Matt takes a look at different ways to protect your portfolio accounts when the market goes south.
Protecting Your Money: Create your own Personal Gold Standard
Everyone invests. Everyone has money. Currency is a form of investment since the gold standard was removed from the currency system.
How to Protect Your Retirement
Coach Matt from Tackle Trading looks at how passive and active investors can insure their retirements against another potential market crash like in the sub-prime crisis of 2008-09.
Tales of a Technician: Tagging the Golden Goose: A Lesson in Portfolio Protection
You’re a goose chaser. Admit it. It’s the gold you seek. And that’s okay. You’re in good company. Most of us round these parts have been searching for the big bird for ages. Some have even tagged one.
Tales of a Technician: A Trick for Financing Portfolio Protection
Come lear a Trick for Financing Portfolio Protection.
I Bought Portfolio Protection…Now What?
Today is the day we layout a game plan for exactly how to manage portfolio protection.
Options Theory: Hedging Basic Series Part 1 – What is Hedging?
What is hedging? Come learn the basics in this 3-part series.
Options Theory: Hedging Basic Series Part 2 – Why do Traders Hedge?
In part one of our new series on hedging, we defined precisely what the concept means. Today we’re turning to the why.
Options Theory: Hedging Basic Series Part 3 – When to Place Your Hedge
With a sound foundation on the what and why of hedging, we’re now ready to dissect the devil. Namely, when do I place my hedge?
Options Theory: Hedging Basic Series Part 4 – How to Hedge a Naked Put
The way that you go about hedging varies depending on what your strategy is. Come learn how to hedge a naughty naked put.
Options Theory: The Protective Put
The options realm is an insurance marketplace where stock owners can acquire protection against loss in their beloved equities.
Options Theory: VIX Spikes and Portfolio Protection
Today I want to talk a bit about the impact VIX spikes have on the cost of portfolio protection.
Tales of a Technician: Managing Protective Puts in a Crash
It’s nailing the management of Protective Puts that separates the men from the boys. Allow me to offer up a few ideas.
Tales of a Technician: How to Trade in a Bear Market
The bears are roaming. And while their sudden emergence likely spelled losses for traders far and wide, the pain doesn’t have to persist. I look at this as a “fool me once, shame on you; fool me twice, shame on me” situation.
Options Theory: This is What Capitulation Looks Like
Contrarians in a bear market seek signs of capitulation. Specifically, evidence that bulls are throwing in the towel and abandoning their once beloved positions.
Tales of a Technician: Of Legacies and Long-term Investing
Herein we explore the perks of lengthening your time horizon and embracing Long-term Investing.
Options Theory: Protective Put Management
You have questions on how to protect a portfolio. I have some answers. You’ll find them here.
Trading Journals
Good traders keep excellent records. Quality trading journals are essential to your progress and growth as a trader and keeping good records will help you learn more from both your income and expense trades.
Learn more about HOW the Tackle Trading Journals can help you become a professional trader.
Reports [Premium Content]
The Weekly Premium Reports are a part of the PRO subscription.
Tackle Trading Playbook [FREE for PRO Members]
PRO Members now have unfettered access to the Tackle Coaches’ personal playbook containing thirty-one powerful trading strategies categorized according to the Options Greeks. Bullish, bearish, or neutral market conditions, this Playbook will help you dial up the right call more often and with greater confidence.
Financial freedom is a journey
Sign up now and gain unfettered access to all of the quality content and powerful Scouting Reports that our Pro Members enjoy for 15-days absolutely free with no strings attached and let us show you what your trading has been missing.
Legal Disclaimer
Tackle Trading LLC (“Tackle Trading”) is providing this website and any related materials, including newsletters, blog posts, videos, social media postings and any other communications (collectively, the “Materials”) on an “as-is” basis. This means that although Tackle Trading strives to make the information accurate, thorough and current, neither Tackle Trading nor the author(s) of the Materials or the moderators guarantee or warrant the Materials or accept liability for any damage, loss or expense arising from the use of the Materials, whether based in tort, contract, or otherwise. Tackle Trading is providing the Materials for educational purposes only. We are not providing legal, accounting, or financial advisory services, and this is not a solicitation or recommendation to buy or sell any stocks, options, or other financial instruments or investments. Examples that address specific assets, stocks, options or other financial instrument transactions are for illustrative purposes only and are not intended to represent specific trades or transactions that we have conducted. In fact, for the purpose of illustration, we may use examples that are different from or contrary to transactions we have conducted or positions we hold. Furthermore, this website and any information or training herein are not intended as a solicitation for any future relationship, business or otherwise, between the users and the moderators. No express or implied warranties are being made with respect to these services and products. By using the Materials, each user agrees to indemnify and hold Tackle Trading harmless from all losses, expenses and costs, including reasonable attorneys’ fees, arising out of or resulting from user’s use of the Materials. In no event shall Tackle Trading or the author(s) or moderators be liable for any direct, special, consequential or incidental damages arising out of or related to the Materials. If this limitation on damages is not enforceable in some states, the total amount of Tackle Trading’s liability to the user or others shall not exceed the amount paid by the user for such Materials.
All investing and trading in the securities market involves a high degree of risk. Any decisions to place trades in the financial markets, including trading in stocks, options or other financial instruments, is a personal decision that should only be made after conducting thorough independent research, including a personal risk and financial assessment, and prior consultation with the user’s investment, legal, tax and accounting advisers, to determine whether such trading or investment is appropriate for that user.
6 Replies to “Tales of a Technician: How to Build a Better Mouse Trap”
I really like your better mouse trap – hopefully we’ll have plenty of time to test it out when the bulls run up consistently, soon.
Tyler – Great article on the cov call strike selection strategy! I am also curious about how to determine the best time to expiration for cov call strikes given weeklies are available on most ETFs. Is there a set of rules or wisdom you can impart when it comes to choosing the right time to expiration for cov calls?
Tyler, I’m your fan.
I got a rookie question: Can I use this 200-day MA technique in any of the stocks I’m currently playing covered calls on?
Hi Christian,
You can. Just keep in mind some stocks behave better around the 200 MA than others. If the stock is hopping above and below the 200 MA like a jackrabbit then you’ll get whipped a little bit until a trend finally materializes.
Excellent article Tyler. Would it also be good to use the SPY 20 year seasonal averages for panning monthly bullish or neutral to bearish cycles and switch back and forth that way as well?
Comments are closed.