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The below are some articles I wrote describing various factors that covered call traders must take into account. These are also available in an easier to read format at Ezine Articles.

Why Covered Call Traders Lose Money

Anybody can invest and get the market rate of return, even my 84 year old grandmother who probably does not even know what stocks are. All you have to do is invest in something like a total stock market index fund. In fact doing this, you will beat around 70% of all the active fund managers.

However, if you want to do better than the market, you better have a plan. Covered Calls is a way to do so.

Covered calls are the most conservative of all the various option strategies. It seems pretty simple but, many people have trouble making money with them. Most of their problems are one of four things: (1) failure to properly screen good covered call candidates (2) failure to monitor and manage your positions once in them (3) not being in enough positions to be diverse and (4) not trading with enough money and thus commissions and taxes take most or all of your profits.

(1) Failure to properly screen positions

I use OptionsXpress and they are great, but at the time of this writing, their covered call screener is lacking. The best one I have found is at Option Monitor. It costs only $35 per month and can screen for about twenty different items. The very useful ones that I use that OptionsXpress do not have are percentage in or out of the money, market capitalization, and percentage above or below the 52wk high or low. Paying another service around $60 or more per month so they can use their “special screener” to show you pre-screened choices is a waste of your money.

Some covered call writers just starting out (like myself) go to a site like coveredcalls.com and look at the highest yielding covered call positions and go to town. This is an absolute recipe for disaster (I lost 40% in three days, luckily I was paper trading). Those stocks are WAY too volatile and are usually tiny medical related companies. A good covered call trader should be very picky in which positions he is going to use.

(2) Management

I learned about covered calls from a guy who was trading during the roaring bull market in 1999-2000 and got absolutely slammed when the market crashed. One of the fundamental things he did wrong was that he failed to set STOP orders for his positions and ended up loosing about 70-80% after he couldn’t produce cash for margin calls. Determining your exit strategy is absolutely vital to any covered call trader.

Another item that deals with management is rolling up, down, or out. Some covered call traders look at just their account balance to see how they are doing.

If your stock has gone down but is still good fundamentally, is rolling down a good option? What if the option has lost all of its time value and rolling out right now can lock in your profit? The bottom line is that you can not just look at the current prices in your account and determine if you should do anything. You need a calculation tool to tell you when you should make management decisions.

I have created and currently use an excel spreadsheet that I think is fantastic. It calculates multiple items such as

Returns if flat and Returns if called out
Current Return based on current prices of the stock and option
Shows a roll-over option for rolling up or down
Downside protection percentage
Percentage ITM or percentage OTM
Warns you when…
When the stock is below the breakeven
When the stock is below the support
Stock > strike for OTM
Stock < strike for ITM

AND MANY MORE ITEMS

The best part is that it automatically updates for the current price of the stock and option

This requires internet connection (obviously), Office 2003, and MSN Money Stock Quotes Add-in (free).
If unable to install add-in (a firewall), the program updates via a web query.

So I generally don’t even go to my brokerage website unless making a trade. I simply update the prices in my covered call calculator and see if I need to take any action.

(3) Diversification

Next is how many positions to trade with? This is a very important question. A great book by Burton G Malkiel, A Random Walk Down Wall Street, has a great explanation about the differences between systematic and unsystematic risk. To summarize, systematic risk is the fundamental risk of the market as a whole. Since the market has risk and all stocks follow the market to an extent, systematic risk CAN NOT BE DIVERSIFIED AWAY. Systematic risk is the risk of the market.

Unsystematic risk is the risk of individual companies such as them getting sued, the CEO getting caught lying to shareholders, or inventing a miracle drug. It is this unsystematic risk that can be diversified away. So how many positions should you get into?
The above book has a graph that unsystematic risk goes down exponentially to zero after twenty stocks (how he got twenty I am not sure, but it makes sense). So should you get into twenty positions? No, because covered calls offer downside protection. My personal feeling is at least five, but preferably seven to ten. More than ten is fine, but I think you are all ready diversified enough and are just wasting your time and trading expenses.

If a covered call trader does not take diversification into account, he/she is asking for trouble. Just like an “investor” needs to be diversified, so does a covered calls “trader”. Therefore, you need to develop some sort of method to track which industries you are currently in. A great way to do that is to use my covered call calculator. In it there is a section to enter the industry so you do not forget which industries you are all ready invested in.

(4) Money Management

Covered calls have their disadvantages, to think otherwise is naive. One of them is that you have double the amount of trades than just owning stock and thus commissions are around twice as much (but usually more since option commissions are generally higher)
Also, if done outside an IRA, there will be short term capital gain tax rates
“Capital gains on assets held for a year or less are taxed at your ordinary income tax rate (anywhere from 28% to 39.6%, depending on your specific ordinary tax rate).

Capital gains on assets held for more than a year are taxed at a reduced tax rate of 20%”
At the time of this writing, OptionsXpress charges $12.95 for an option buy or sell (but $0 for being called out) and $9.95 for a stock (these are both the active trader discount, both go up to $14.95 without the active, however if you do not qualify for this, you are not following rule #3). So the minimum transaction cost per position is (2x$9.95 + $12.95) $32.85.

The following is an explanation of how much you should invest in per position taking into account taxes and trading costs. Let us assume a standard profit of 3% per position (this is very reasonable). The following is how much money 3% is for different amounts of position values.

$2000 - $60
$3000 - $90
$4000 - $120
$5000 - $135

Make the decision for yourself, but my cut-off is a minimum of $4500 per position. However, the more the better. (note that this $4500 is the net debt per position i.e. stock minus option premium)

How do you know what the total “cost basis” is for a position before you enter it? Easy, just use my Covered Call Calculator and enter the starting prices and number of contracts and it will tell you.

So the final question is how much money you should you start out with. Based on $4,500 per position and having five positions leaves $11,250 trading on full margin. Note that this does not take into account a positions where you are forced to put more money than $4500 since you are forced to place orders in increments of 100 shares (which is a certainty).

Taking the above into account therefore a good amount of money to begin trading is $15,000. Anything less, you must accept that extra risk.

Covered Calls - In The Money (ITM) Versus Out Of The Money (OTM) And Which Is Best For You

Anyone just starting out in covered calls needs to decide if they want to focus on an in-the-money (ITM) or an out-of-the-money (OTM) strategy. This is a significant decision that will have important effects on your long term success and that amount of success.

Benefits of ITM

More Protection: ITM strategies obviously offer more downside protection than OTM. You will make the same amount if the stock goes up, stays flat, or goes down to a certain percentage that it is ITM. (%ITM is the % the stock must drop to reach the strike price {$purchased - $strike}/$purchase)
This is a HUGE advantage because ITM systems are more forgiving of price fluctuations and mistakes on the trader's part.
Since an ITM trader is more likely to be called out at the end of the month, every month you will research and find the highest yielding CC positions that meet your requirements. Compared to an OTM strategy, you are more often left with the stock at the end of the month since it did not rise to the strike price. When you write another call for the next month it may not have a high premium anymore because the "market excitement" that caused the premium to be high in the first place has disappeared for whatever reason (for example a quarterly earning report was what initially caused that excitement has passed).
I believe this reason is very minor compared to the first one. It can probably be ignored, but I added it for completeness.
In a down-trending market, which happens about 30% - 40% of the time, an OTM strategy simply does not work. This is because the vast majority of stocks follow the market to an extent (defined as Beta). It is very hard to find up-trending stocks in a down-trending market. So in a downward market a CC trader can select positions perhaps 6% ITM or more and be successful. However in this scenario, the premium received will be much smaller than in an upward market so the trader must trade with enough money per position to prevent trading costs taking up all his gains.

Disadvantage of In-the-Money and Advantages of Out-of-the-Money

Trading Costs: Since an ITM strategy has more positions called out at the end of the month, trading costs will be higher. In a scenario where the stock is flat, there will be two stock orders and on option order for an ITM position vice on stock order and one option order in an OTM position.
Higher R-multiples in ITM: The max R-multiple is the ratio of the max amount gained divided by the amount lost if the position is stopped out. Since OTM positions make more money if the stock goes up, the max R-multiples are higher for OTM positions. Thus OTM strategies follow more to an extent the old trading adage "letting your profits run." (I say "to an extent" because all CC strategies limit the upside, regardless if it is ITM or OTM.) This is why OTM strategies can potentially be more profitable, but more risky.
Since in an ITM strategy, you will be called out more frequently at the end of the month, you will need to research more positions every month. This will take more of your time (whether this is good or bad depends on you). In an OTM strategy, you will more often NOT be called out. Then you would simply sell another option on the same stock that would give the highest premium. This saves time because the majority of your research time is on the stock, not the option.
For my next point, you need to understand one of the four greeks: delta.

In options, delta is the amount an option goes up or down when the underlying stock goes up or down by $1.00. Options ITM have deltas closer to 1.0 compared to options that are OTM.

So for example, say you are in an ITM position that the stock just went up $3. The option has a delta of 0.8, so the option went up by $2.40 ($3 * .8), which is a debit in your account. So in total your position went up $3 - $2.40 = $0.60.

In another example, you are in an OTM position that went up $3 whose option delta is 0.6. Thus the option went up $1.80 (or debit in your account) and your total position went up $3 - $1.8 = $1.20.

It is the OTM scenario where you are easier able to do a roll-out to capture a quick gain in the stock. (A roll out is buying back the call and selling the stock prior to expiration). This is much harder in an ITM strategy because when the stock jumps, so does the option by almost the same amount.

This is a HUGE advantage to OTM strategies. A good OTM CC trader will use auto-roll-outs frequently. In these cases, he would not have made as much money if he would have waited until the end of the month, but rolling out early completely removes the risk of the stock dropping again later. Additionally, he can take that money and re-invest it in another position. Like I said before, this is a HUGE benefit to OTM traders.

Which Strategy is best for Me?

In a downward market, an ITM strategy should be the only option. Some will look at a covered call screener and still see high yielding OTM positions. However, these stocks are more likely to head south and you will be stopped out. Remember, 100% of the risk is in the stock.

In an upward market, I initially thought that the only people who should trade OTM are people who fully understand the concepts of position sizing and expectancy. But any CC trader should understand these concepts (see Trade your Way to Financial Freedom by Dr. Van Tharp)

I now believe based on my own experience that whether or not someone should trade OTM CC's is based on one thing: experience. It strongly recommend that any OTM trader should have prior experience as a trader of any kind. This experience can be an ITM strategy or any sort of other system.

Another option if you think you are somewhere in the middle is to trade both ITM and OTM. Perhaps you could have half of your positions in ITM and the other half in OTM.

Covered Calls - The Disadvantages and What You Can Do To Avoid Them

If there is anyone out there who thinks covered call is the perfect trading strategy with no disadvantages needs to face reality. There are two problems with covered calls, one of which is enormous, let alone all the other things you can do wrong in ANY trading strategy. It seems to me that covered calls are a type of strategy that people hear about from somewhere without realizing that it is trading, and if they do not understand the fundamentals pitfalls of trading AND covered calls, they will fail.

The fundamental problems with trading in general are too vast for the purposes of this article. However to summarize, they are your own personal mentality and position sizing. I recommend reading Trade your Way to Financial Freedom by Dr. Van Tharp.
The two major problems with covered calls are that it limits your upside potential and to a lesser extent the extra trading costs since you buy the stock and sell the call. This is what you can do to mitigate these effects…

Transaction Costs:

Compared to a standard stock strategy, the transaction costs are roughly double or more than double since the option trading costs are generally higher than the stock.

To counter this, you need to trade with enough money per position. I can not say this any more simply. However, let’s examine just how much OptionsXpress’s transaction costs are for an active trader (which if you do not qualify for, you are not following good position sizing). In this case, the minimum charge for the stock is $9.95 and the option $12.95. Thus the minimum amount for a full position is $22.90 if you are not called out at the end, $32.85 if your ARE called out, and all the way to $45.80 if you roll out early to lock in your profit.

A good standard amount for covered call traders is 3.5%, some will be more and others less. So let’s look at how much you would make trading various amounts earning 3.5%.

$2,000 - $70
$3,000 - $105
$4,000 - $140
$4,500 - $158
$5,000 - $175
$5,500 - $193

Also taking taxes into account, (lets say 20%) how much are you comfortable trading with now? If your initial positions were $2000 do you still think this is adequate? What about the positions where you only get 2.5% ? This decision is entirely yours, but my opinion is that it is silly to use any position sizes less that $4,500 per position, preferably more.
(An entire other topic is how many different positions to get into at once, which I will not get into here, but to summarize my view, at least five)

Limiting your Upside

One of the golden rules people like to quote for trading is to cut your losses short and let your profits run. However, in covered calls you can not “let your profits run” since it limits your upside. To understand how to deal with this, one must understand the differences between probability and expectancy.

Probability – the percentage of time that each position is “right” or you make money. Most people assume that a trading system where you are wrong 80% of the time is horrible and you are sure to loose money. But what if when you were right that 20% of the time, you made 10 times as much per position when you were wrong? Would this be a good system? Yes it would.
But in a covered call strategy, being “wrong” 80% of the time would not be good, since when you “win”, it is impossible to make much more than when you loose.

Expectancy – How much you make per amount risked, given in a number times “R” written in the format of “0.5R”. This means that overall each position you risk “R” and overall you make “0.5 * R”. Here is an example.

Suppose you buy ABC stock for $28.20 and sell .abc call for $1.20 (the strike does not matter here). Looking at the chart you decide to set you stop at $26.20 and you will buy back the call at market (using a “one triggers other” market order). But you do not know what price you will buy back the call, so you guess you will buy back the call for 20% of what you sold it (I base this on experience). In this case you will buy back the call at $1.20*0.20 = $0.24.

So the amount you risk is ($28.20 – 26.20) + (0.24 – 1.20) = $1.04. Thus 1R=$1.04.

Lets say at the end of the month you were called out and you made a good 3.5% which correlates to $0.945 ( = ($28.20 – 1.20) * .04). Note the 3.5% is taken from the NET-DEBIT and not the stock price.

So for this position your “R-multiple” is the amount you made divided by the risk or
0.91R = ( $0.945 / 1.04 ). Note that if you lost money, this would be negative.

This is your R-multiple for this single position. To determine you expectancy, you must take the average of ALL you “R-multiples”. An expectancy greater than 0.0R means you make money.

The next point is how high can each “R-multiple” be for each position? Or how much can each position make compared to how much I risk in each position? The answer varies, but on average most positions I enter have an R-multiple of 0.6R, few getting above 1.0R (the ones that do have more to do with where the support is on the chart compared to my stock purchase price). Compared to other trading strategies, this is not good. A trend following system can have high max R-multiples of 10R or even 20R, which is impossible with covered calls because it “limits your upside”. But trend following trading systems are “right” maybe slightly better than average, lets say 55%. Thus in order for those to be profitable, the 55% of the time has to be greater R-multiples than that of the R-multiples when they loose. Thus on average, the mean of all their “R-multiples” will be greater than one and they make money.

So my overall point on how to get around the fact that covered calls limit your upside is this…

Since covered calls have low max R-multiples, you have to have a high probability trading system.

You WILL have positions stopped out. This is inevitable. However, you have to keep these as infrequent as possible or you will have too many negative R-multiples and when you average them all together, your overall system expectancy will be negative. Because of this, it is my preference to only do an ITM strategy since these are significantly more likely for me to NOT be stopped out. Furthermore, I like only medium to large stocks reasonably priced that actually earn something.

Some may be thinking if I keep my R’s very small (by keeping very tight STOPS) then my R-multiples will be large. This is entirely true, but you will find that you will get stopped out a LOT and you trading costs (that other bad thing about CC’s) will overpower any profits you make. You have to give your position some room to move.

Another option I suppose may work is to shift to high yielding CC opportunities, such as the potentially most profitable OTM positions that would be on coveredcalls.com. These are very volatile and STOPs would be frequent, but occasionally you will get that “winner” making a lot and hopefully enough to overpower you losses to get a positive expectancy. This is a much riskier strategy but potentially more rewarding. You have to have a lot of control and a good position sizing strategy for you not to get destroyed. This is past my acceptable level of risk, but it may not be past yours.

For those of you wondering what my probability and expectancy are, my probability is 82% or I get stopped out 18% of the time. My expectancy is 0.16R, which I admit is lower than is desirable. However in my defense, in my early trading days I did not understand what I do now about controlling risk. It scares me sometimes looking back at my earlier positions that if I would have been stopped out I would have lost up to 5% in my account! These types of positions resulted in very small R-multiples for profitable positions, and thus lowered my overall expectancy.

Another point that must be said is that I have only been trading CC’s in an upward market. I believe that CC’s will also work well in a downward market, but they must be much more ITM, perhaps up to 10%. In this scenario, the total profit would most certainly be less than in an upward or sideways market.

Covered Call Trading Exit Strategies - the Pain of STOP Orders

Any good trader needs to view trading as a business. A good covered call trader needs to set exit strategies as soon as he enters any position. The goal is to maximize your gains and minimize your loses. However, this is often a challenging thing to do, and if done incorrectly can cause lots of pain.

All covered call traders should absolutely use STOP’s to sell the stock and a “one-triggers-other” (OTO) order to buy back the call at market. One of the most painful aspects of a new covered call trader is setting STOP’s poorly and losing a lot or getting STOP’d out for just normal price fluctuations.

The best way to set STOP orders is to use the closest support. To find the support, it is easiest to use an interactive chart (OptionsXpress, Stockcharts.com, or BigCharts.com) and use the low value on the day with lowest price, not the closing price. Set the STOP at least $0.50 or 2% below the support, whichever is less. For example, if you set the STOP $0.50 below the support, this must correspond to at least 2%. If not, then keep going. The idea here is that the stock will test support. This is a usual thing and healthy. Many times the stock will break support slightly, but come right back. You have to allow enough room for the stock to move past support before the STOP.

Another question you must ask is how much percentage will you lose if you are stopped out? The problem is that the price you buy the call back for is unknown, but most certainly less than what you paid. A good guess is that you will buy back the call for 20% of what you sold it for. However, this is highly dependent on time left to expiration. I personally do not like losing more that 6% on a position. If I lose, lets say 12%, all my other positions combined will probably not make up for this one loss and I will have a negative month.

So what if this support corresponds to a loss greater than 6% (this happens a lot)? You either do not enter that position (which I do not recommend), or find another less strong support or use another arbitrary value (perhaps the overall net-debit or cost basis).

Do not set the stop at a dollar value. Market makers know this and will move the price to get these automatic orders

As a guy in the military, I like procedures, so here is mine…

Find the nearest support on the chart by finding the lowest value (use the low for the day, not the close)
Determine if 50cents below the support corresponds to at least at least a 2% move from the strike price. If not, keep going down. (This is dependent on the price of the stock, cheaper stocks are more volatile so 50cents is good and more expense stocks 50cents is almost nothing)

Analyze how much your position will lose if called out. If greater than six percent…

Look for another less obvious support or choose an arbitrary value. Perhaps you don’t want to lose anything and can use the net-debit or cost basis
Ensure the STOP is not set anywhere in the vicinity of .95-.05 of any dollar amount. Market makers know this and will force the stock to drop to profit from all the stupid people who set their STOP’s at whole dollar amounts.
Go to you brokerage and set a STOP limit “one triggers other” order. The buyback of the call should be a “market” order. Ensure you chose a “good until canceled” (GTC) STOP order for the stock.

NOTE: OptionsXpress automatically sets the option order as a market DAY ORDER. The effect of this is that if this occurs in the end of the trading day, you may not be able to buy back your call. Therefore the next trading day you will have a “naked call”. Unfortunately there is no way around this, but fortunately this is rather rare. The things you can do to minimize this is
(1) ensure your positions have calls with an open interest of at least 500 and (2) check your positions daily (which you should do anyways)
Every time you get STOP’d out, DO NOT GET EMOTIONAL. Trading is a rational event. Analyze what happened and is there anything you could do better in the future. No one gets good at anything without constant self evaluation.

I have made a covered call calculator I created and use myself. All of the above calculations are done automatically.