Options Theory: Picking the Right Stock for Covered Calls | Tackle Trading
I received an email the other day from a trader that bought a few stocks and has been selling covered calls against them. He had questions. I have answers. Here we go.
“I purchased X , AMAT, and HOG. I have lost money on the stock but did well on the Covered Calls. It seems I should keep selling them.”
Let’s talk about stock selection. You have two choices when selecting what to buy for covered calls. You can buy an individual stock, or you can buy an ETF. The former offers more volatility, the latter less. The first is only better if you pick a stock that ends up rising more than the overall market. The second is better because you are guaranteed to get whatever the market is willing to give (assuming we’re talking about IWM, SPY, QQQ and the like). Stocks have pesky earnings announcements every quarter to deal with. So you either have to make sure you own a small enough amount to deal with these overnight gaps without puking, or you have to use protective puts to limit risk.
In the case of X, AMAT, and HOG, they’ve all dropped while the market has been rising. What a bummer! We’re in a bull market, but this trader unluckily chose the few stocks that aren’t participating. Such is the risk of the stock-picking route.
Traders choosing individual stocks to play covered calls with must have a good track record of stock selection. At least, that’s what would make me comfortable with that approach.
As for continuing to sell covered calls, well, it depends. If you planned to continue cash flowing these for the foreseeable future, then yes! You’ll need the call premiums to keep streaming in to reduce your cost basis in the stock further.
Trade or Investment?
“AMAT took a big hit after earnings. Again dropping my stock value way down. From what I can tell, it broke a major support area. So, what do I do? Do I hang on to the stock and hope it goes up? I don’t like how far it dropped. I have lost ~$485 on the stock but making money on the options. I purchased 100 AMAT at 48.44 and now it has dropped to 43.65. I am selling covered calls on it but…a lot of money to make up. Do I get rid of it all and call it a loss since it has broken support?”
First, it’s never a good sign when someone asks me this type of question. It reveals they didn’t have a detailed trading plan before entering the trade. If you haven’t pre-planned your exit then how do you know what your risk is? And if you don’t know what your exposure is then how do you know how many shares to buy?
If you weren’t comfortable with the potential for a down-gap after earnings, then you shouldn’t have held the stock into the event. Or, you should have bought puts to protect.
When I enter a covered call, I decide at the outset if this is a stock I want to hold for the long run or if it’s just a trade. The only reason I would want to keep it for the long haul would be if A) I was comfortable with the fundamentals of the company, B) I owned few enough shares where I’d be willing to ride through earnings announcements and corrections, and C) I was comfortable with my entry price.
If the only reason I bought the stock was that I liked the chart, then it’s just a TRADE. Because if the stock breaks support and I no longer like the chart, then my reason for entry is no longer valid. Thus, I exit.
I agree AMAT broke major support, but it’s oversold so a short-term bounceback could be in the cards. The stock has been in a daily downtrend since April so it wouldn’t have been on my radar for a covered call to begin with.
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Originally published at https://tackletrading.com on August 23, 2018.
