Good questions, Jennifer

Jennifer’s question from my previous post: LINK

There is the rub of writing covered calls: What if the stock price goes down. The answer is: depends. Primarily on what you think of the stock/company at that time. Is it down because of company news? Is it down because the market in general is down? Do I think it will recover?

I have gone through all of these over the last 5 months that I have been writing this blog. I have developed a couple of rules of thumb:

  • I try to buy slightly out-of-the-money (3-5%) covered call positions and make 3-5% per month on the option premium, 1 to 2 month options, net of commissions.
  • If the stock is called I make a little extra, if not called I want to be able to write a call again at the same strike price and make a decent return. I will not cry if I get to sell several contracts before the stock is called away.
  • If the stock falls to the point that there is little to no premium at your strike price for the forseeable future (4-5 months), seriously consider buying back the option and selling the stock.
  • Your opinion of the underlying stock/company plus what the overall market action has to determine whether you keep a falling stock on the belief it will recover or you sell and reinvest elsewhere.

Having said all of that, I believe I have held on to my losers to long in the past and try to make an early decision to sell.

As to the actual trading, it is not hard. You can go to the Trade King website and click through the screens to see what they show. Once you have an account open you can enter trades in the screens and see how they work. You get a preview before the trade is sent in so you can cancel if you want. You can also easily cancel pending trades.

Start small, pick out a trade you would like to make and see if you can get it filled at a price that works for you. If you have a stock in mind let me know and I will review some trade possibilities for you. Your questions give me good stuff to write about.

Comment answer

Jennifer asked a question on getting started trading covered calls. Thought I would post my answer again:

I hope reading through this blog helps you get some understanding about covered calls. I have been reading about option trading for years, and finally wanted to give it a try so I opened an account using the funds from a small IRA I had in a mutual fund. I started with about $4000.

I think the best way to learn is to just open an account and make some trades. Once you have an account (I use Trade King) you will find trade screens set up for the different option strategies. There will also be research tools to help you find trades. I use an option screener to find stock in the volatility and price ranges I am interested in.

I have found that I am developing a strategy that works for me and my temperament. Everyone that trades has their own style. Read the blogs in my blog roll and read others that you find interesting.

Option Trading Ideas

1 Option Trading is having a open house of the website and premium trading service. If you scroll down you can link to his actual recommendations for 3 levels of service.

It is interesting to see how difficult it is even for a seasoned professional to be consistantly profitable trading options. Makes me feel a little better about some of my trades that do not go the way I want.

Effect of Commissions

In my previous post, I gave the details of a recent covered call trade. If you add up the commissions for a called covered call trade, the total commission for a 100 share/1 option trade is $15.50.

To diversify my account I am making trades in the $1000-$1200 range, to give me up to 4 open positions at any one time. This makes the commissions approximately 1.5% of of each round trip trade. If I average trading the portfolio 9 times a year (50% one month trades & 50% two month trades), my total commission costs are 13.5% of the portfolio value.

Obviously it is important to figure all trades net of commissions to see if the profitability is acceptable. A 3% raw gain reduced by half becomes unacceptable.

If a stock is not called and I can write another call on the same stock the cost for that round trip is reduced by 1/2%.

The biggest thing I can do to reduce the negative effect of commissions is to trade in larger dollar amounts. Trades in the $2000 range reduce the commission drag on gains by half. So as my account grows, the results should improve just by the lower percentage that will be taken by commissions.

Trade King online brokerage

Trade King has worked very well for me as the brokerage for my account. They have low fees and a ton of information on their website. I have learned a lot over the last couple of months just from the info available there.

Trade King has a $50 referral fee paid to account holders (i.e. me) who refer by email someone who opens a new account. I have added a link in the right column of this blog if you would like to have information from Trade King emailed to you. If you open and account I would be paid the referral fee. I think it is a great idea, but do what you want, no pressure.

Trade King referral

What the heck am I doing?

My last post was about rolling the option on one of my deep in the money calls up in strike price and out in exercise date. Well that is not working so well!

Over the last 2 days EEE has fallen from $10.48 a share to a current $8.61. I had a Feb $7.50 call which I sold and bought a Mar $10 call. Right now I would be much happier if I had held onto the Feb deep in the money call.

The lesson learned here is to not get greedy. I had a good profitable position with very little risk, and I traded it for a more profitable (possibly!) with much greater risk. Each time I have messed with a position before expiration of the option, it has cost me.

Step by Step investment strategy

Since I was exercised out of my position in GRA, I now had cash to invest. Over the last month I have been experimenting with the options scanner at Trade King to find the kinds of opportunities that coincide with what I am trying to accomplish. So here is an outline of the steps I went through to find today’s investment.

  1.  With the options scanner my main criteria is implied volatility. I have found that I need options trading at greater than an IV of 50 to get the returns I am looking for. So I entered a range of 50 to 70 for the IV. I picked a stock price range to keep me in the amount I wanted to invest. Moneyness from 5% out to 20% in and March call options. I selected to show 20 possibilities in ascending order of IV.
  2. I then punched each of the resulting stocks into the Motley Fool CAPS to get an idea of what and how the company was doing. This weeded out a few obvious bad eggs.
  3. Next was comparing the stock price to option strike prices and value. I entered each stock into Trade King and called up the option chain for March. I eyeballed each for time premium, moneyness, open interest and price spreads. This narrowed the list down to about half a dozen.
  4. Back to Yahoo and MF CAPS to review recent price trends, news and predictions. At the same time I am entering the stock and option prices into my option calculator to calculate the expected returns. I ended up with a couple of stocks right at the money with good call premiums.
  5. I attempted to place a trade for FRG but could not get it filled at the price I wanted. Right at the end of the day I put in an order on CHINA which was filled. CHINA trades at a much higher volume so was easier to get filled at the price I wanted.

Even though I was looking at March contracts I ended up buying CHINA at $9.99 and selling the Feb10 call for $.55. This works out to 4.5% expected return for 26 days. The annualized return for the March contract was about the same, so I elected for the shorter term call.

Item of interest: It appears a implied volatility of 50 equals about a 5% per month option premium for at the money calls. I will be looking at different volatility levels to see if there is a correlation.