This is a guest post by Mike Scanlin of Born To Sell.
"Covered call" investing is a popular and conservative options-based income-oriented strategy. According to a recent Wall Street Journal article, 84% of Charles Schwab option-enabled accounts trade covered calls. Because of the downside protection granted from the call premium received, they are more conservative than their nearest cousin, the buy-and-hold strategy.
However, like all investment strategies it is possible to lose money with covered calls. There are ways to reduce your risk and stack the odds in your favor. A lot of it has to do with staying away from high risk situations, but there are also positive things you want to look for.
Here are the top 10 ways to improve your covered call investing:
1. Avoid leveraged ETFs. Leveraged ETFs, which are like normal ETFs except they use 2x or 3x leverage to magnify the results compared to an unleveraged ETF, are mostly day trading instruments not designed to be held over night. Not appropriate for covered calls. You can usually identify leveraged ETFs because they have words like "ultra" or "leveraged" in their names.
2. Avoid companies with earnings release dates before option expiration. Stocks are extra volatile just before and after an earnings release date. While that volatility can make for attractive call premiums, you don't want the underlying stock to drop 20% overnight because of bad results or poor guidance.
3. Don't count on the FDA. When there is an FDA announcement, biotech and pharmaceutical stocks tend to get cut in half or double instantly. In either scenario, covered calls are not the best strategy to take advantage of that kind of volatility. You will rarely get enough premium to cover the downside case and if you're going to take the risk then why put a cap on your upside?
4. Avoid thinly traded stocks. Large volume makes for small spreads. The opposite is also true: thinly traded stocks and options have large spreads. These large spreads will cost you if you need to exit your position early or make an adjustment to your position. Better to stick with highly liquid stocks, or at least avoid the illiquid ones.
5. Avoid options with low open interest. Similar to #4 above, you don't want to be in an option series that has low open interest. If you ever need to exit early you are unlikely to get a fair price in a series with low open interest. The series should have at least 2000 contracts of open interest, but as little as 1000 is probably okay.
6. Don't chase highest return without knowing why. It's easy to find the top yielding covered calls but those need to be viewed with a skeptical eye. Why are those options priced so high? Is there some pending news announcement? Or is the stock a momentum play? Or a short squeeze? There's almost always a discoverable reason for juicy premiums and you want to make sure you know what it is before getting involved. Do some research.
7. Position sizing is important. Don't put all your eggs (or even 20% of your eggs) into a single investment. If you have a small portfolio, limit each position to no more than 10% of the portfolio value; larger portfolios should target no more than 5% in a single position. If you can't meet those goals then consider doing covered calls on diversified ETFs which have built-in diversification.
8. Dividends before option expiration are good. If the stock is going to pay a dividend then set yourself up to receive the dividend as well as the call premium. Look for ex-dividend dates before option expiration. Be aware, though, that if there is very little time premium remaining in the option on the day before the ex-dividend date then you may be subjected to early exercise.
9. Diversify. Don't put all your covered call trades in the same industry sector. Spread them around to different sectors to avoid too much sector concentration and correlation. And, again, if your portfolio is on the smaller side then consider broad-based ETFs as they are a basket of stocks and remove much of the single-stock and single-sector risk.
10. Be prepared to own the underlying stock. Even the best laid plans sometimes don't work out. If you're selling short-term in the money or deep in the money options with the expectation that they will be called away, realize that they may not be called away. You may end up owning the stock after expiration. If you're not comfortable with owning it then choose a different stock for a covered call.
Mike Scanlin is the CEO of Born To Sell, a web site dedicated to covered call investing. He has been investing in options for over 30 years. You can read more articles from Mike on his Covered Call Blog.