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Covered Calls: A Passive Options Strategy

Covered Calls: A Passive Options Strategy

I’ve decided to pivot towards a more passive option approach with covered calls.

The reason is twofold. First, I haven’t done well with options (except for August) because of mistakes I’ve made.

Back in November, after the surprise election of Donald Trump and the ensuing stock market melt-up, my option positions blew up and I lost around $1,500. My account size at the time had been around $10,000 so that is a big, big percentage loss over a short period of time.

The second reason is I don’t have free time during trading hours.

Reason One: I Made Mistakes

It should not have mattered much when the markets moved a lot. I pay to follow Kirk DuPlesis’s trades over at Kirk was only down around 2%. I was down around 15% even though I was in very similar positions.

Why the difference?

The main mistake I made is that I only had about $100 in free margin, which is a big no-no. I should have had $5,000 in margin available. Because I only had $100¬†when the markets went crazy I didn’t have any dry powder to make adjustments add additional positions to balance out the portfolio or hold positions to expiration.

Kirk was using around 50% of his available margin, so he is able to hold positions to expiration, make adjustments, sell additional premium, and keep his portfolio diversified.

It’s frustrating because while I know the rules I wasn’t following them.

Follow the Rules to Be Successful

To be successful trading options long-term there are several inviolable rules: small position sizes (1-5% of the portfolio per trade), only use half of your available capital, and place a lot of trades so the probabilities work out.

There are other factors too, like using the correct strategy, making high probability trades and being on the right side of volatility, among others.

But I don’t follow the rules! I’m afraid of missing out on a trade, or I allow myself to make an exception “just this once”, or I get greedy. And it burns me every time!

So I’m putting myself in time-out.

I’m going to stop trading options for a while. I haven’t had the discipline to follow the rules that must be followed in order for the math work out in my favor and be successful.

Reason Two: I Have Less Time

Not only that but I don’t have the free time I did when I was seeking out a new, full-time career.

Even though it might be possible to trade options and work a full time job it’s hard. One is confined to placing limit GTC orders before or after work or trading over lunch. However, a lot of the market movement tends to happen in the 30 minutes after the market opens and 30 minutes before the markets close.

When I was doing a lot of trading (July-September) I didn’t have a day job. I had this website, option trading, and selling coins. I set my own schedule.

Now I’m on the road or in appointments 8-9 hours a day during trading hours and I rarely have time to place 3-4 trades 30 minutes before the markets close. I don’t have time to make the appropriate adjustments to existing positions and I don’t have time to look for new trade opportunities.

I need a more passive approach.

Covered Calls

So I’m winding down my existing option positions. I’m also increasing holdings in some of my Value Stock Picks and selling some covered calls on them.

Covered calls they work like this: first buy shares of a stock, say 100 shares of Acme Amalgamated for $40/share. Then sell an out of the money (out of the money for a call option contract would be a contract with a strike price above where the underlying stock is currently trading) call contract for a theoretical $100 premium. 10% out of the money would be a $44 strike price.

A call contract legally obligates the call option seller to sell 100 shares of the underlying stock to the option contract buyer at an agreed upon price (the strike price) at any time before the contract expires.

For a more in-depth introduction to covered calls I suggest checking out Investopedia.

With the covered call approach, I sell an out of the money call with a strike price about 10% above where the stock is currently trading, with a contract expiring 30-60 days out, and I buy 100 shares of the underlying stock. This provides some downside protection, regular income (from the option premium) and the only downside versus owning the stock outright is gains are capped at 10% until the contract expires.

With covered calls three things can happen.

1) The stock goes down

In the above example, the stock price could drop as low as $39 at the time of expiration and the position would still break even. Because even though $100 would be lost on the price of the stock (if one were to sell) the call option would expire without being exercised and the $100 premium is still retained.

If the stock fell below $39 a loss would occur, but it would be $100 less than it would otherwise be.

2) The stock goes up or down a small amount, or stays the same price

A $100 profit would be realized plus or minus the gain or loss of the stock. If the stock price was below $44 at expiration the sold call would expire worthless and not be exercised.

3) The stock goes up beyond the strike price

In this case the position would return about 10%. It would be $400 gain plus the $100 option premium. One could either close out the call contract for a wash/loss or just let the position get assigned and the 100 shares of ACME bought for $40 per share would get sold for $44 per share.

So by selling covered calls, you give up some upside potential in exchange for some downside protection and recurring income.

But if I could make 10% every 60 days I’d be thrilled. Lets say the stock is on a tear, and it goes up 15% in the first 30 days and I get assigned, I’d still make 10%. I could then buy the stock back and sell another covered call 10% out of the money, at the end of 30 days the stock goes up another 15%, I would have still make an additional 10%, etc.

I think it is a good strategy if you can execute it correctly. Plus it doesn’t take a lot of time.

Some important elements:

1) Picking a good stock

I want to sell covered calls on stocks (or ETFs) that I want to hold for the long term. I’ve previously talked about what metrics I use for selecting stocks.

Another strategy, for example, is to buy an S&P 500 ETF like SPY and sell covered calls on it.

2) Discipline

You need to limit risk and diversify in non-correlated assets. It’s a temptation to buy into the latest hot stock and sell calls on it, or try to use too much leverage on a position. Another temptation could be buying too much stock in a given company or industry.

I would like to go back to trading options in a more active way someday. And I’m not saying I won’t make the occasional earnings trade but if I get back into actively trading options it will require puritanical adherence to the rules.