Welcome to The Stock Market Millionaire podcast. This is episode number 12, “Selling Covered Calls The Right Way.”
So, what are covered calls? A covered call is when you basically own a stock, and you sell or rent a call option against it. So basically what you’ve done is you purchased the stock, and let’s say, we’ll put numbers to it, let’s say you bought the stock at $10, and you gave somebody the right to buy it for you at $12, so $2 higher than it’s trading for right now, and for that right, somebody paid you – let’s say just to make it real round numbers – they paid you a dollar. So, you bought it at 10, you gave someone the right to take it away at 12, and they paid you a dollar for that right.
So, why would they do that? Well, if you think about it, let’s say the stock goes to 20. Because you took on an obligation when you sold that covered call, you are now obligated to sell that stock at 12, right? Because they had the right to buy it from you at $12. You can’t go, “well, I kind of changed my mind” because that’s kinda too bad, right?” That’s the biggest draw down or draw back to a covered call position is that, if at the stock goes higher, you give up the upside potential. So you think there’s a potential for your stock to take off, covered calls might not be the best strategy for you.
Now, is selling covered calls the same as covered call writing? I get this question all the time. The answer is yes. When we sell a covered call, we are writing a covered call. “Writing” is synonymous with sell or selling. So yes, it is the exact same thing.”
So what type of positions can cover calls be written on? You can write them on stocks. You can write them on some indexes. And a great method is covered call ETF, right? I am a tremendous fan of using ETFs, exchange traded funds, the spiders (SPY), the diamonds (DIA), the NASDAQ (QQQ). All of those are ETFs that covered calls can be written on.
So let me give you a few of the steps that I use for my personal covered call strategy, and I am a tremendous fan of writing covered calls. The first part of my strategy is I prefer, personally, to do these in a retirement account. There’s a reason for it. In a retirement account. I don’t have to worry about long-term capital gains, short-term capital gains. I have any of that issue to deal with. Do I, did I own the stock less than a year, more than a year has no bearing whatsoever on me. You can’t do them in a traditional, regular brokerage account, but I prefer them in a retirement account.
Also, I believe that retirement accounts should be safer, meaning I should have a little bit more caution, care in the trades I want to make. Not just stocks, with the trades I want to make. I’m not taking as much risk with my retirement money as I am with my non-retirement money. I’ve got more opportunity, and if it goes down a little bit, I’m looking for bigger rates of return so I’m willing to risk a little bit more. It may take you 20, 30, 50 years to build up your retirement account,; I don’t want to see you lose it in 20, 30, 50 minutes. So, I like them. I like covered calls in retirement. That’s what I use all the time, my retirement, are these types of strategies.
And we’ll hit some other podcasts which have the other two major ones, which, you got covered calls ready we’re talking now, I love selling naked puts or what are called puts for cash inside of an IRA, and then diagonal spreads as well.
All right. So the steps for picking the stock or finding the right stock is, I look for stocks under 40. And actually I look at a range of $8 to $40. Can you go higher? You can. It just becomes costly buying the equity on that high of a price stock. That 25 to 30 is dollar level is an ideal level for me if I can get enough premium on the options, which we’ll talk about. So first filter criteria stocks under 40.
Second one is of course it has to be optionable. How am I writing an option on it If it doesn’t have, if it’s not an optional, right? And we’ll get into the options detail in a minute.
Thirdly, I’m looking for at least 1 million shares in volume traded every single day. What does that mean? I need to know that at least 1 million shares transfer hands every day on that stock. We are so active in the market these days, I mean, there are people that have never been involved in the market before. It’s fairly easy for a decent company to hit a million shows a day. When I saw, I want to see at least a million shows a day, and then I’m looking for a bullish to a neutral pattern. And what does that mean? I don’t want to drooping down. You know, the expression “don’t catch a falling piano,” or “don’t catch a falling knife?” You look up, the piano is falling from the sky, right?
Somebody just dropped it off the 35th floor as they were pulling it up hoisting with a rope, the rope broke. Don’t try to bridge and support yourself to catch it, get out of the way and help pick up the pieces after it hits the ground. I don’t want to do that on my stock and say, “at some point it’s going to bottom out.” I don’t want to do that. Let it fall, let it do its thing, and I’ll worry about that candidate later, I’ll go find a different candidate to trade for now. So a bullish pattern, I want to going up; a neutral pattern, I want to going sideways, I just don’t want it going down right. That I’ll pass on that one for now.
Alright, great. We found a list of three, five, 10, 20, whatever it is, potential candidates. Now we go and look at the options details, right? I am a big fan of selling the front-week option. Meaning, here it is Friday, I’m selling next Friday’s option, or it’s Monday, I’m selling this Friday’s options. That’s me personally. I love weekly options for covered calls. Actually it asks has to be a really, really good deal for me to sell an option that doesn’t have weekly options on it. To buy that stock and have to wait a couple of weeks for that trade to go through, it’s not for me, but that doesn’t mean it’s wrong. When I first started, that’s all we did. We only had monthly options. So we would write a covered call that had up to six weeks of time being sold. And that is the match. You don’t want to, some more than that, you, you lose your theta burn, which is your benefit as a seller, and I want to make sure that you have that available to you. You want theta, time value deterioration to go away. That’s a benefit as a trader.
So, front-week options, maximum six weeks. From there, I’m going to look at Delta. Delta tells me, and we have this, I’ve talked about this in one of the other podcasts we get into the options details a little bit, and Delta is one that we actually have a separate podcast we’re going to do on that in the coming future. But Delta tells us, for every dollar, the stock moves, how much has the option move.
We’re looking for, as a seller, we’re looking for a Delta of about 40 ish. Now, I would much rather go if it was 45 and 32, I would go to the 32. But 45 is closer. Yes, but I really don’t want to go over 42. That’s kind of, for me, pushing the envelope. Could you? Yeah, there are times I’ve done higher Delta, but that’s where I’m not trying to buy the stock, rent it out this week and hopefully have it again next week and I do it the week after and, after and, after and after that’s where I buy the stock, I rent it out right at the money, I bought the stock at $35 and 2 cents, And I sold the $35 call. And I get the highest time premium because I’m selling the, at-the-money, I just have a better chance of being taken away. So if you don’t care about it, having taken away, then you can go with a higher Delta. Just be careful if you start stepping, what’s called in the money, when you have cash value, you don’t want to have to give the stock, give cash back if they take the stock away from you, right. At least I don’t.
So you find the right stock. You find all the option details workout. Now, what are you going to do? You’re going to place what is called a buy/write. Buy/write with a net debit.
What does that net debit mean, then? You bought the stock at 10. You sold the option for a dollar. I am doing a buy/write with a net debit of $9. I’m spending 10. I’m getting one. The debit is nine. Buy/write within that debit. That allows me to negotiate both the spread of the stock and the spread of the option at the same time. Yes, at the same time. And by doing so by negotiating both of them, I can take a higher advantage to my benefit because I’m negotiating both at once. So I’m basically adding the spread together. Now you’re looking for a third or a half off on the spread. You’ll get used to based on the stocks you trade how long you’re willing to wait for this to come to you, you’ll figure out what it is. Start with a third of the bid-ask spread. And then you can move to as much as half. Any more than half you’re being a pig and the market makers, probably not going to play nice, so I wouldn’t even bother. But you make the call on what you’re going to do that.
And then once you’re in that position, what do you need to do? You manage it, you manage it. How do I manage the position, Rob? I want you to forget about everything I just told you covered calls for just a couple of seconds now. Don’t forget it-forget it. That would be a waste of your time, but forget it for a few seconds. Pretend you bought the stock at $10. Where is your uncle factor? What’s the uncle factor. You know, when someone twists your arm? “Uncle, uncle,” right in a wrestling match or something, where do you say “all right, that’s it, the pain threshold was hit.
I’m done, wore out. I don’t want this stock, this particular stock. If it goes down below nine, doesn’t look good for it. Great. Then you send an order up that says, if the stock gets down to $9, get me out of the trade, and you manage that trade by buying back the call option that you sold. You sold to open, you buy to close on that covered call, right? That’s the way that I like to manage my positions out there. I’m a big fan of management. I will look at every chart every night and it takes me from my open positions under five minutes to look at all of my charts. I don’t have hundreds of stocks open.
I’ve got a half a dozen, maybe enter 10 positions open at one time. So it takes me fairly, fairly short to look at all of them. Once I’ve analyzed all of the positions, once I’ve done everything that I need to do, I’m done for the night, unless a change has to be made. And the change would have to be made as if it hit my “uncle factor,” I’ve got to get out of that position. Other than that, my week is fairly short with the amount of time that I spent here. Management is not a complex thing, but you’ve got to find the right groove for yourself. What are the management techniques for you?
All right there, you have it. Ladies and gentlemen, you have a great rest of your day. Stay focused on the quest to becoming a great trader, keep crushing it. And remember, you’re just one trade away. Take care, and I will see all of you at our next update.