Here are 10 tips to improve your chances for success with covered call writing:
Tip #1: No 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 to drop 20% overnight because of bad results or poor guidance.
Tip #2: No biotechs/pharmaceuticals
When there is an FDA announcement these stocks tend to get cut in half or double overnight. 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 (e.g. ARNA in Sep 2010; went from 7 to less than 2 on a negative FDA announcement) and, if you’re going to take the risk then why put a cap on your upside?
Tip #3: No leveraged ETFs
Leveraged ETFs (which are like normal ETFs except they use 2x or 3x leverage to magnify the results of an unleveraged ETF) are mostly day trading instruments not designed to be held over night. Not appropriate for covered calls.
Tip #4: No 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 hurt 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.
Tip #5: No options with low open interest
Similar to #7 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 open interest, but as little as 1000 is probably okay.
Tip #6: Don’t chase highest return without knowing why
It’s easy to find the highest yielding buy-writes but those need to be viewed with an inquisitive 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 fat premiums and you want to make sure you know what it is before getting involved. Do some research.
Tip #7: Dividends before option expiration are good
If the stock is going to pay a dividend then why not 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 early exercise.
Tip #8: Position sizing is important
Don’t put all your eggs (or even 25% of your eggs) into a single investment. If you have a small portfolio, try to 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 buy-writes on diversified ETFs which have built-in diversification.
Tip #9: Diversify
Don’t put all your buy-write trades in the same industry sector. Spread them around to different sectors to avoid too much correlation and sector concentration. 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.
Tip #10: Be prepared to own the underlying stock
Even the best laid plans sometimes don’t work out. If you’re selling short-term ITM or deep ITM 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 buy-write.