Covered Call Trading Vs. Buy-Write Trading Part 2

Ask The Option Scientist

ris Ebert, author of the popular option trading book “Show Me Your Options!” and frequent contributor of option related articles on zentrader.ca often receives questions from readers. Do you have a question for the Option Scientist? Email questions to optionscientist@zentrader.ca. Email addresses will not be published.

The following is part 2 and the conclusion of a response to a reader's question about the use of stop losses and price targets in covered call trading.

In Part I the reasoning behind the opening of a covered call trade was explored. As it turns out, there are different reasons for opening a covered call on stock that is already owned, and opening a covered call at the same time the stock is purchased, known as a buy-write trade.

On stock that is already owned:

Given the possible outcomes, a covered call sold on stock that is already owned is most advantageous when it is observed that the STOCK HAS HIT RESISTANCE and is expected to either trade sideways for a time, or to experience a minor pullback in price followed by a resumption of the uptrend.

On stock that is purchased as a buy-write:

Given the possible outcomes, a covered call sold at the same time a stock is purchased, also know as a “buy-write”, is most advantageous when it is expected that the STOCK IS UNLIKELY TO ENCOUNTER RESISTANCE in an uptrend.

A BUY WRITE IS NOT THE SAME AS A COVERED CALL

How can this be? A covered call opened as a buy-write is best done when a stock is in a strong uptrend, while the same covered call opened on stock that is already owned is most beneficial when a stock hits resistance?

They are technically the same trade, but the reasons for opening them are different. The stock owner is looking to hold onto a stock that is experiencing temporary resistance by generating some income that will either add to previous gains or offset some temporary losses. The buy-write trader is generally not interested in a long-term relationship, but rather wants to get in and get out quickly with a profit.

A strong uptrend can actually be a poor outcome for the stock owner who sold a covered call with the expectation of a temporary correction. While the covered call will produce additional profits for the stockholder, the unexpected uptrend may lead to an overbought condition in the stock. As a result, the stock that once was a long-term prospect for this trader may suddenly lose its attractiveness. The stock owner may believe that continuing to hold the stock after an extended uptrend is too risky when compared to other stocks that are in the beginning or intermediate stages of an uptrend. Additionally, the trader must admit that the prediction – that the stock would not push through resistance – was incorrect. If it was not possible to predict how the stock would behave last month, how confident can the trader be about the ability to predict next month's behavior?

Replacing the stock with another can require long hours of analysis; and despite the number of stocks available, a good stock that fits a trader's goals can be difficult to replace. Meanwhile, the buy-write trader is likely to be quite happy with the outcome, and may be puzzled by the stockholder-turned-covered-call-trader's displeasure. After all, they both earned the same profit!

WHAT GOOD IS A BUY-WRITE?

The advantages of selling a covered call on stock that is already owned are easy to understand. Doing so allows the stock owner to hold onto a stock during periods of indecision or weakness in the market, without needing to sell the stock and re-enter the position at a later time. But the advantages of selling a covered call as a buy-write trade may not be so clear. It was shown earlier in Part I that the best outcome for a buy-write trade is for the stock to experience a strong uptrend without experiencing resistance. So why bother with a buy-write at all? Why not just buy the stock outright?

If a stock is in a strong uptrend, then simply owning the stock without selling a call option is likely to result in a larger profit than would be experienced on a buy-write. For example: If 100 shares of stock are purchased at $50 and the price suddenly rises to $60, the trader can sell the stock and walk away with a $1000 profit. But if the trade is opened as a buy-write by purchasing the stock at $50 and selling a call at the $50 strike for a $5 premium, the maximum gain will be limited to $500. In a strong uptrend, owning the stock outright almost always makes more sense than owning it as a buy-write.

The trader is left with a psychological quandary. Buy-write trading is most advantageous during a strong uptrend, but a strong uptrend is more beneficial to owning the stock without selling the call option. There is a simple solution to this quandary. The trader can only know in hindsight that buying the stock was going to be a better trade than the buy-write. In the absence of an ability to predict the future with 100% certainty, it is not possible to know in advance which would be the better trade.

Buy-write trading has a distinctive advantage for traders who can not flawlessly predict the future (and that's most of us!). It produces profits when the prediction is correct and a strong uptrend materializes. It produces profits when the prediction was somewhat correct and the stock price only moves up a little or not at all. And it produces profits when the prediction was incorrect and the stock price declines, to an extent. A trader who focuses on picking stocks that appear

likely to benefit from a buy-write (i.e. those most likely to experience a strong uptrend) must prepare to occasionally be faced with buyer's remorse, or more appropriately, seller's remorse.

From time to time there will be that V8 Moment when it becomes obvious that buying the stock would have produced a larger profit than the buy-write. The easiest way to deal with this form of remorse is to take a bit of advice from some of the market's old-timers: “You'll never go broke taking profits!” Buy-write traders will earn a profit more often than stock owners because stock owners can not profit from a sideways or downward price movement. Buy-write profits, although they may occasionally be smaller, are still profits; and profits are the key to not going broke.

STOP LOSSES AND PRICE TARGETS

While the reasons differ for opening a covered call all-at-once as a buy-write, or as a call sold against stock that was purchased previously, the reason for closing each trade is the same – it has either reached its price target, or it has experienced its maximum allowable loss. Although the rules differ from trader to trader, there are some guidelines that many find helpful.

CLOSING THE CALL OPTION: Never keep a covered call open when the ask price of the call has fallen below $0.25! Once the ask price falls below that level, the amount of additional potential profit is usually too small to justify the risk of keeping the trade open. On a standard call option controlling 100 shares of stock, the difference in profit between an ask price of $0.25 and a ask price of zero is just $25. When the ask price gets that low, it often makes good sense to buy the call option to close it rather than wait and hope it will expire worthless. The extra $25 is usually not worth it. It is not necessary to sell the stock to close the call option, so that choice will depend on the profit or loss of the stock itself and the trader's long-term goals surrounding the specific stock involved. Some traders may choose to sell an additional covered call on the same stock when the initial call option is closed, using either a lower strike price or a more distant expiration date.
STOPPING LOSSES: As a general rule, do not allow any single trade to cause a loss of more than 2% of the total account value! For example: On a $25,000 account, losses should generally be stopped before they exceed $500. On a standard covered call controlling 100 shares of stock, that would require a stop loss of no more than $5 for a $25,000 trading account. If a stock is so volatile that a $5 stop loss is not feasible (such as a stock that often moves $5 in a matter of hours) then covered calls on that stock should be avoided entirely until the account size is larger. If the stock is sold in order to cut losses, many brokers require that the call option be closed too. In any case, once a covered call trade reaches the maximum acceptable loss it is good trading practice to exit and move on to more promising trades.
BUYING A PUT OPTION: When a single covered call trade requires a large portion of the trading account, buy a put option to prevent catastrophic losses! For example: On a $25,000 account a standard covered call controlling 100 shares of a stock that is trading at $125 per share requires placing $12,500 at risk, or 50% of the account. A negative development such as a bankruptcy or a market crash could affect the stock price overnight, and a stop-loss order would not be able to be executed until the following trading day – when it might be too late to prevent catastrophic damage to the account. Buying a put option at a strike price somewhat lower than the strike price of the covered call ensures that the account will never be wiped out by a single trade. The put option will not prevent all losses, just catastrophic ones. Many refer to this type of protection as a “Collar”.
HITTING A PRICE TARGET: Never keep a covered call open longer than necessary when it has experienced a substantial profit! It is possible for a covered call to experience near-maximum profit long before expiration
day. This often occurs when the stock price makes significant gains. For example a covered call sold at the $50 strike price might experience near-maximum profit if the stock price rose to $60. There is very little to be gained by getting greedy, but a lot to lose if the trend suddenly reverses. Walking away from a covered call with a $400 profit after just a few days is often preferable to taking a chance at walking away with a $500 profit after a month. Although no rule is best for every trader, closing a covered call after it has experienced 80% of its potential profit is often preferable to holding on for the final 20%.
CHOOSING A STRIKE PRICE: Don't get greedy for capital gains; capital gains are for stock traders!. Covered call trading is about making small profits, consistently. There's an old saying in the stock market: “You'll never go broke taking profits!” When a stock is trading at $50 in a raging bull market, sure, it makes sense to use a higher strike price of maybe $55, that way it's possible to get a $5 capital gain on top of the covered call premium. But it's also possible to enjoy profits by selling the covered call at the $45 strike price; and when markets are questionable, the $45 strike price often makes more sense. For example, the $55 strike call may have a premium of $2.50 per share while the $45 strike may have a premium of $7.50. It is worth noting that should the stock price remain flat at $50 through expiration, both trades will return the same $250 profit. So while the potential capital-gain profits on the $55-strike covered call may initially seem more appealing (it could potentially return a $750 net profit), the fact is that the $45-strike covered call has a much better chance of returning a profit, albeit a smaller net profit ($250 is the maximum). Don't be afraid to use in-the-money strike prices!
CHOOSING THE EXPIRATION DATE: Don't be afraid of more distant expirations! Weekly options have become very popular in recent years, but that does not mean that they are always the best choice for a covered call. In general, the only time a covered call using a weekly expiration will outperform one using a more distant expiration is when the stock price remains flat or only moves slightly. If the stock makes big gains, the weekly covered call will quickly reach its maximum profit. The more distant expiring covered call has a higher initial premium, thus a higher profit potential. The more distant expiration can therefore continue to profit long after the weekly expiration has been maxed out. In much the same way, a stock that experiences big losses will often result in a bigger loss for the weekly covered call trader than for one using a more distant expiration. In a quick downturn, both call options can become worthless. That's good, because they can each be closed at a profit in order to offset some of the losses on the stock. But the weekly option has a lower initial premium, so there is less profit to offset the stock loss.

Once a covered call trade has been opened, the reasons for opening it do not matter. Whether is was opened as a buy-write in expectation of a quick gain, or opened on previously-purchased stock with the expectation of riding out a period of resistance and indecision, once the trade is open a covered call is a covered call is a covered call. Therefore, the above rules apply regardless of the manner the trade was opened or the reason it was opened. By following the rules, a trader has a better chance of surviving, whether it involves covered call trading on stocks that are already owned, or buy-write trading on stocks that are purchased at the moment the call option is sold.