What is a Covered Call?
A covered call is an options strategy where the investor holds a long position, and sells call options against that position. This strategy is typically employed when an investor wants to generate extra income off of their positions and they believe the price of the underlying stock won’t move either up or down in the short term.
Finding the Stocks:
So many people know that they want to invest in something and even take the first few steps in making this idea a reality. However, a lot of these get lost in the information overload that happens when it comes to analyzing stocks. Is this stock going to go up or go down? Should I focus on fundamental or technical analysis? Do I follow a major firm like Icahn and hope for the best? Am I going to trade options or normal Equities? What should I look for in a company? What companies are good? The list goes on forever…
Now, imagine that you answered all of these questions and you had a strategy that could pick the best stocks that will earn you almost double the S&P500. The only thing is that every stock doesn’t match this profile and this strategy will result in you spending hours scouring the market for that one golden egg… or at least that’s how it used to go. Thankfully for us we have the power of technology, specifically our computers and the programs on them. Programs such as screeners allow us to input our golden egg strategy once and it will scour the market for us, responding with every stock that fits the profile in a matter of seconds. It’s actually fairly magical. Because it is so easy to scour the market using a screener it is always my first stop when it comes to analyzing the market for stocks to invest in.
For this article we are looking for stocks with good fundamentals that have had a history of increasing in price because covered calls are always a neutral/bullish play.
When writing a covered call screen we care less about how much a screener makes over time and more about how many stocks win/lose over time.
- First, we want to make sure we can actually write an option for the security
- The earnings per share in the last quarter needs to be higher than the dividend per share. This ensures that the company isn’t overpaying dividends to its investors at an unsustainable level.
- The dollar volume over the past ten days needs to be over $1 million
- The shares outstanding needs to be shrinking over the past 80 days.
- The change of the stock’s closing price over the past year needs to rank in the top 90% of the market
- The P/E needs to fall between 0 and 20
So what kind of stocks does this screen return?
Now, how does this screen perform over the past three years?
Alright, not too bad. 22.14% a year isn’t anything to scoff at. Now remember, this is just the basic screen. Now we need to go ahead and change a few settings to simulate what would happen if you were writing calls against these long positions.
- Since we are trading stock options a buyer can exercise their option at any point during the life of the option we need to place a stop gain around the point that a person would tend to exercise their right to buy. After a bit of research we decided that the best stop gain is roughly 7%.
- We also need to adjust our definition of a good return and a bad return.
- We set a bad return to -4%. At this point, the option is going to expire worthless and we are typically around or underneath our breakeven point. Stocks that fall on the -4% line should either be sold or held if there is still a bullish outlook.
- We set a good return to 4%. At this point the option will expire in the money, but the buyer is less likely to exercise this option if there’s only a 4% gain. In the event the buyer doesn’t exercise you will receive the premium + the appreciation in the stock price. However, we want to assume that the buyer will exercise the option, in which case you will still be able to collect the whole premium.
Let’s run that backtest.
Okay, so as you can see we didn’t earn as much as we did before. On the other hand when we take a look at the heat map we can see that a large majority of the positions we took on were winners. If the majority of the positions win then we will be able to collect our premium more likely than not.
Now that we’ve verified that this strategy works we need to figure out which security we want to trade the options on.
Looking at the results we want to pick a stock that has consistently increased over the past five years and does not have an ex-dividend date within the next month.
After taking a look at the results of the screener I think our best option is Aetna(AET).
Trading the Option:
So now that we have our stock, it’s time to head on over to thinkorswim, or whatever brokerage platform you use, and analyze the options associated with that stock.
As you can see, AET is currently trading at $116.86/share. AET also has an ex-dividend date on 7/14/15, that means we need to trade an option that expires before that date as the stock price tends to fall on the date of the ex-dividend. Focusing on only the options of mid-June and early-July we have strike prices that range from $115-$118.
This part is where personal preference comes into play. The amount of risk you’re willing to take will determine which contract you choose. Personally, I want to collect as much premium as possible, and I think that AET will easily go above $118/share by the end of the first week of July. This trade will allow me to collect $3,840 in premiums when I purchase 1,000 shares and sell 10 calls against those shares.
Alright! Now that we’ve gone through the entire analysis process let’s make that trade on our EquitiesLab experimental account and start looking for new strategies! We will keep you all updated on the status of the account as we release more articles based on how you can use EquitiesLab to not only become a better investor, but a smarter investor.