Covered calls are one of the most popular strategies to get steady income in options trading, but most investors do not make the most out of it or even end up making avoidable mistakes. This guide will uncover some key insights into selling covered calls effectively, managing risk, and ensuring your strategy lines up with market conditions.
Understanding Covered Calls and Alternatives
In general, a covered call typically includes owning 100 shares of stock and selling call options on them. Such an operation earns income but could trigger that nasty situation of being “called away” when the option ends in the money.
In Fig Leaf Strategy, Learn a Smarter Alternative
It’s called the Fig Leaf strategy—a term coined within the Options Playbook—an alternative to the traditional covered call. You don’t actually buy the stock outright. You hold deep in-the-money call options, with a right to buy the stock. The benefits are similar, but you have to pay a bit more attention because time premium and income are on a seesaw basis.
Advantages of Fig Leaf Strategy
- Lower out-of-pocket costs than having to buy 100 shares.
- Flexibility to manage the position without risking full stock ownership.
- Ability to generate income through call selling while limiting capital exposure.
Why Target 30-Day Options?
When selling calls, targeting options with 30 days to expiration is key. Here’s why:
- Time Premium Balance: Thirty-day options offer an optimal balance of time decay and premium collection.
- Low Assignment Risk: Options with a Delta near 10 minimize the risk of assignment. A Delta of 10 means there is a 10% chance that the option will expire in the money.
- Consistency: With a six-month deep-in-the-money call, you can theoretically sell new calls every 30 days to create consistent income.
The higher Delta options, for example, 20 or 25, might earn better premiums but also carry greater assignment risk, thereby sabotaging your strategy.
Handling Time Premium and Income
Sell calls not to abandon the underlying but to:
- Strike the time premium: Seize the time value trapped within the deep-in-the-money call.
- Generate income: Earn back the expense of carrying the option via a constant flow of premiums collected.
- Adjust to volatility: Modify your approach according to the performance of the underlying stock and market conditions.
Timing Considerations: Avoiding Earnings-Related Mistakes
Earnings announcements and other significant events may cause substantial price movements that increase the possibility of assignment. To minimize this:
- Do not sell calls during earnings dates: Volatility is unpredictable and may lead to an uncertain outcome.
- Wait for post-earnings clarity: Sell calls after the earnings announcements so that it coincides with more stable market conditions.
Being aware of the company’s event calendar helps you manage positions effectively and avoid unnecessary risks.
Real-Life Examples: Caterpillar vs. Nvidia
Caterpillar: A Structured Approach
Caterpillar was in a bullish trend during the time it was managed in the portfolio. Calls were sold almost every month, following a structured plan to:
- Collect premiums consistently.
- Reduce the overall cost of the deep-in-the-money call.
- Capitalize on the stock’s relatively stable price movements.
This approach worked well because Caterpillar exhibited predictable performance with low volatility.
Nvidia: Managing Volatility
Nvidia presented a different challenge. With frequent news updates, earnings surprises, and price gaps, managing covered calls was more complex. Instead of selling calls, the strategy involved holding the deep-in-the-money call options and riding the stock’s bullish trend.
Key Takeaways:
- Do not sell calls when volatility is high: Better to let the position ride if the stock has explosive growth potential.
- Adjust to the nature of the stock: Each stock is different, so each needs a different strategy.
Common Mistakes in Selling Covered Calls
There are several costly mistakes investors make when selling covered calls. Here are the most common pitfalls and how to avoid them:
- Not taking into account timing: Selling calls at or around earnings or in volatile periods increases assignment risk.
- Focusing only on high premium: High premiums may appear attractive, but they often carry more risk.
- Not watching Delta: Choosing options with poor Delta values can result in unwanted assignments.
- Being too passive: Strategies such as the Fig Leaf require active management to adapt to market conditions.
How to Succeed with Covered Calls
To succeed at the highest level, follow these best practices:
- Research thoroughly: Understand the stock’s volatility, earnings calendar, and growth potential.
- Align strategy with the stock: Stable ones should have structured approaches, whereas volatile ones should have more flexible strategies.
- Target low Delta options: Target ones with a Delta near 10 to minimize assignment risks.
- Do not overtrade: Do not sell calls unless there is alignment with your conditions.
Conclusion
Selling covered calls is a powerful strategy for generating income, but it requires careful planning and execution. Whether using traditional covered calls or more advanced approaches like the Fig Leaf strategy, timing, volatility, and risk are important factors to understand.
By avoiding common mistakes and tailoring your approach to each stock, you can build a consistent income stream while minimizing risks. Stocks like Caterpillar and Nvidia demonstrate the importance of adapting strategies to market conditions, ensuring long-term success.