Hello Tackle Traders! I had a question come to me this week in regards to covered calls? What are they and what are they good for? Of course there were lots of follow up questions like how to I build one, how do I manage one, how do I close one etc? These are all good questions and all very normal questions for those who are not well versed in the art of the covered call. I thought I would take the time in this weeks blog to talk a little about our friend the covered call. This is a strategy that I adopted early on as a trader and its really never disappointed me so why not give it its due? So this week we will go over basic structure and the concept of the covered call and then two separate approaches to the covered call that are similar in nature but slightly different in thought process.

First up is the concept of the covered call. Covered calls are just an avenue to increase one’s cash flow from owning stock. In the old days before options trading, one only had one way to extract cash flow and that was through the dividend route. There is nothing wrong with just sitting back collecting some free cash from the dividends but this slow drip can be less than satisfying for some folks and the return on investment may not meet expectations as well. In comes the covered call as a secondary source of cash flow. Essentially a covered call is making a promise to someone to sell your stock to someone else for a specific price for a specific length of time. This gives ownership control to the buyer of the option and gives premium (aka extra cash) to the seller of the option or the maker of the promise. This premium received can add a tremendous amount of ROI (aka return on investment) to the prospect of holding onto the stock.

Now that we have covered the “coles notes” version of the covered call concept we can talk about the basic structure of the trade. This is also a simple concept. We need to buy shares in lots of 100 shares as one option contract covers 100 shares and this is the promise made, sell 100 shares for the agreed upon price or the strike price as it is called. Once the shares are purchased we then find the strike price of the contract we like and then we sell that contract to collect the premium. This completes the basic transaction but there is one more consideration and that is the length of time that we are willing to make the promise for. This can be a long time or a short time and it all depends on the traders point of view. There is however a “sweet spot” of time and that is in the ballpark of 30 days. This is where the connection between premium and time meets in a very efficient way.

This covers the basic structure and the concept of the covered call and the final piece of this puzzle is the two different approaches to doing a covered call. The difference between the two approaches is the managing of the stock. The first approach is the concept of wanting to keep the stock longer term. The pride of owning the stock and the plan to continue collecting the dividends and just enhancing the overall yield. This approach means that the overall ROI of the covered call is going to be small in comparison to what it can be with the second approach but it means that the dividends will make up for the loss of difference in ROI. With this first approach, you will most likely be holding onto the stock for an extended period and even perhaps forever. This approach requires a fair bit of due diligence in the fundamental department as the longer one holds the stock the better the company has to be.

The other approach looks for a larger ROI and puts less emphasis on owning the stock for an extended period of time. This approach is looking for more volatile equities and therefore more premium in the promises. The ROI in this scenario can be multiples higher than the first approach and there is an emphasis placed on the exit strategy. In this approach one must exit this trade at a pre-determined amount of loss. Keeping the stock in this scenario is less advised as these stocks are not going to hold the same fundamental strength that the first approach will. The execution of each of these trades is the exact same except for the strike price that is agreed upon, The strike price in this scenario will be much closer to the actual price of the stock. This will naturally increase the ROI and make the risk much more attractive and potentially worth the loss that can be realized if the stock price drops to the point where we need to get out of the trade.

You can see by these descriptions that these two trades although they use the same mechanism they are very different in nature and can be employed for different reasons and different outcomes. When deciding which one to do it is imperative to take into consideration the nuances and then being very clear on the outcome one is looking for on the trade. So mull over each of these approaches and see how they may fit into your trading repetroire.

In the blog next week we will go over a candidate for each approach so that we can visualize how each trade can work and when it makes sense to use each one.

Until then,

Trade Well,

Coach “Old Money” Holmes