4 Rules for Trading Covered Calls Successfully

We've heard a lot about politicians and Wall Street executives employing a "C.Y.A" strategy to divert blame from them and on to somebody else during the current financial crisis. But when it comes to options trading, a "C.Y.A." strategy means something a little different.

In the options context, C.Y.A. stands for Cover Your Assets (rather than the more colloquial meaning ascribed to the term C.Y.A.). The "cover" when it comes to options is the practice of writing covered calls. Covered call writing is perhaps the most elementary and conservative of all option strategies. It is so conservative, in fact, that it is the only option strategy allowed in retirement accounts.

The best way to approach covered call writing is to look at the options market as a business, and the objective of your covered call business is to produce a monthly cash flow. The merchandise with which you run your business, then, would be the stocks you hold in your investment portfolio.

If you own common stock, you should be involved in the business of covered call writing. If you are not, then you are letting your inventory go to waste. For example, when you own rental property, you rent out the space. If you own a bookstore, you sell books. The same analogy can be made with the stock market.

The major advantage of covered call writing as an investment strategy is that it is far safer than just owning stocks or mutual funds. Covered calls allow you to generate an immediate cash return on your stock holdings, and the income (option premium), you receive, offsets possible declines in the stock price.

Last year we bought 100 shares of Coeur d'Alene Mines (CDE | Quote | Chart | News | PowerRating) stock at a price of $4.70, and then sold (or wrote) a CDE Sep 5 Call for an option price of 40 cents against the stock position. In this scenario, the option premium (price received for selling the option) provided an immediate 8.5% return on the stock position. It would also offset an 8% decline in the stock price while providing a possible 14% total return if the stock rose and was "called away."

Using Covered Call with Caution

Covered call writing is not as easy at it sounds. There are some decisions you must make, and reducing those decisions to a couple of critical underlying objectives is a good idea. Those objectives are to (1) maximize income, and (2) minimize portfolio risk. To achieve these objectives, you should attempt to generate covered call returns of about 20% annually.

There are also two primary challenges to take into consideration with covered call writing. One, your downside risk is only reduced, not eliminated. And two, your profit potential is limited. A covered call requires you to sell the stock at the strike price, regardless of how high the stock might go up.

The most important decision you'll have to make with your covered call business is selecting the right stocks to buy. This, of course, is the quest of investors everywhere. But as they pertain to covered call writing, here are some guidelines for stock selection:

1) Select stocks with high volatility. Higher volatility leads to higher option premiums and more income generation. Options on volatile stocks also tend to have better liquidity, which could help you to secure better option prices.

Given the high level of volatility in the market right now, finding stocks that fit this criterion shouldn't be a very difficult task.

2) Select stocks that are in an uptrend. Just as importantly, try to avoid stocks that are in a downtrend. Owning stocks is a bullish investment strategy, and writing covered calls does not change a bearish outlook on a stock to a bullish one.

Finding stocks that are in an uptrend may be the most difficult aspect of a C.Y.A. strategy right now. But despite current market conditions, finding quality stocks will in an uptrend will be the norm again - we just have to get through this current selling flu.

3) Favor low-priced stocks over high-priced ones. Stocks priced at $10 to $20 per share have a tendency to command higher option premiums, commensurate with the stock value. The higher options premium will add to your overall profits in the long run.

4) If your covered call is assigned, let the stock go. You will be selling the stock for a profit to your trading account. Then you can take a step back and decide whether it is worth buying again.

By following the guidelines of my C.Y.A. strategy, and with some active management when necessary, you should be able to increase your stock returns by up to 20% annually - while reducing your risk. And let's face it, anything that can reduce your risk in this market is a welcome strategy.

Ken Trester started trading options when the first exchanges opened in 1973. He has been a computer science professor at Golden West College in Huntington Beach, CA, where he also taught a course on stock options trading. Ken is also widely quoted in publications such as Technical Analysis of Stocks & Commodities and Barron's.

Ken is the editor of Fast Options Profits and Maximum Options, both of which provide options trading recommendations for beginning to intermediate traders.