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Timing And Covered Call Writing

12/23/13 06:13:28 PM
by Billy Williams

By using the right approach with covered call writing you can earn predictable returns and end up owning the stock at no cost if you play it correctly.

Security:   NLNK EJ
Position:   Hold

There are a number of challenges that traders face each day, the most common being timing your entries, interpreting the trends, risk control, trade management, and picking the correct underlying instrument to trade. But, there are uncommon challenges that you have to take into account such as emotional control, right decision making, the stress from unpredictable returns and the anxiety over trade positions that don't conform to average holding periods. Before you trade, all of these challenges have to be accounted for and, more importantly, included in your planning so that there is no doubt at any stage of the trade — before entry, after entry, managing the position, profit taking. Any doubt as to what to do at any stage can lead to poor decision making and a breakdown of discipline that can lead to meager results or, worse, severe drawdowns.

For you, as a trader, it's important to eliminate as many unpredictable variables as possible while being confident in your trading method and comfortable with it at the same time.

Figure 1. On December 4, 2013, NLNK was trading above its 20-day and 50-day SMA before pulling back and offering a low-risk entry at around $20.25. The stock resumed its uptrend, and with expiration day approaching on December 20, 2013, is showing divergence in its Williams %R that indicates the stock is oversold and/or approaching a top. At this level, you could sell a covered call option that would yield between 6.70% to 17.80% in just a few days.
Graphic provided by:
One of the strategies to help you accomplish this, as well as eliminate some of the unpredictability of expected profits and unknown trade holding periods, is writing covered calls.

Writing covered calls is a hybrid strategy of holding stock while selling call options on the position. Like renting a house, you sell call options on stock holdings in increments of 100 shares which lowers your cost basis and gives you both predictable income while defining your holding period to the call option's strike price and month of expiration. Plus, it allows you to calculate your profit in advance as well as know how long the trade will take before you can bank your profits.

If the stock reaches the call option's strike price by its expiration date, then it can be called away by the option buyer. This occurs on average about 75% of the time but, if you time it right, then you can avoid being called away and repeat writing covered calls on the same stock position. Again, like renting a home, eventually the mortgage is paid for and you own the home outright, and so it is with the stock position where each time you successfully write a covered call that isn't called away, you eventually own the stock at no cost.

Figure 2. EJ also offered a low-risk pullback entry at around $10.50 near the end of November 2013 before it resumed its upward trend. As price moved up, its Williams %R indicator also reveals divergence indicating an oversold condition and setting up to write a covered call. The DEC $14 calls are priced at around $50 which would yield you a 4.80% return for a few days till expiration on the 20th ($50 in call premium/$1,050 in stock = 4.80%) if you're not called away. If you are, then your yield could be as high as 33.33% ($50 in option premium collected + $350 in capital gains/$1,050 in stock = 33.33%).
Graphic provided by:
A solid approach to using this strategy is to look for stocks that are priced $20 or lower that have high option premiums on slightly out-of-the-money (OTM) call options with less than three weeks left till expiration. The reason you want less than three weeks of time left on the OTM option is that time decay will work in your favor as the call option loses value the closer it gets to the expiration date.

NLNK pulled back in price earlier this month and offered a low-risk entry in the stock at around $20.25 before resuming its upward trend. As the stock began its upward move, using a leading indicator like Williams %R, you would look for any signs of indicator divergence or an oversold condition. This is the signal point to sell an OTM call option, which in this case would be the DEC $22.50 call that is currently priced at $1.35. The option expires on December 21, 2013 and could yield a 6.70% return if not called away ($135 option premium collected/$2,025 worth of NLNK stock = 6.70%) or a 17.8% yield if called away ($135 call option premium collected + $225 in capital gain collected from the stock sale/$2025 worth of NLNK stock = 17.80%).

This type of approach and strategy is practical for beginning traders with limited funds but you have to be careful of commission costs. The above example doesn't factor these added expenses, but if you choose your broker carefully, the transaction costs should be minimal. Factor them into your trade beforehand.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

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Date: 12/25/13Rank: 3Comment: 
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