Yesterday a live meeting with members of my Portfolio Accelerator service…
It was a chance to tell them about the three new plays I’ll be establishing…
As well as, answer a few questions…
One of them…I’d like to spend some time with…and address it here.
When is the best time to sell covered calls on underlying stock positions?
Not only will I address this question, but I’ll also share with you the mechanics behind the strategy…along with the one simple rule I apply to squeeze out every penny of profit I can…
A call option is a contract that allows the buyer to buy a specified number of shares at a specified price during a specified time period.
The seller, or writer, of the call, collects and keeps a premium.
The downside of covered call writing is that if the stock trades above the agreed-on strike price, the shares will be called away, and you will have to decide to buy your shares back or move onto the next stock.
It’s usually considered to be a very conservative strategy as you can collect a lot of cash in return for giving up some upside potential.
But the collected premiums also offset some of the damage if the stock declines during the option period.
Traders should have covered calls in their toolbox as well.
Instead of selling a stock when it nears the trigger point of your indicator, begin selling covered calls on your overbought holdings.
You were going to sell it anyway, so missing out on some of the upside potential is not that big a deal.
Just collect a few extra percentage points on the way out the door.
Keeping Your Momentum
Here is an example of a simple trading covered call strategy that should work.
For our indicator, we will use what is widely known in the trading community as RSI, or relative strength index.
The relative strength index is a momentum used by traders to determine if a stock is overbought or oversold at any given moment.
The RSI can also provide us with information about the strength or weakness of a particular trend in a stock or market.
The RSI is usually displayed as a line on a chart that oscillates between zero and 100. The standard lookback period for RIS is 14 days, but it is usually a good idea to also look at slightly longer and shorter periods to get a better picture of the price action in the stock you are considering
The rules are pretty simple.
A stock that has an RSI under 30 is at or nearing the point where the shares are oversold and can be getting ready to bounce higher.
A Relative Strength reading over 70 indicates that the stock is oversold and maybe getting ready to cool off and pull back.
The Relative Strength Index was developed by a noted technical trader.
The concept of RSI was first introduced in Wilders 1978 book New Concepts in Technical Trading Systems. It has become a widely used indicator, and traders use it just about every conceivable tradeable market to measure momentum.
Now that we know what a covered call is and have a better understanding of how to use RSI to measure momentum, let’s set up a trading system that incorporates covered calls as an exit strategy.
Here’s an Example
First, we want to look for stocks that have broken out of an oversold condition.
We can use a screener to look for stocks that trade above 30 but below 40. Keep in mind a screen is just a start in the process. You need to take a peek at the charts and make sure that the RSI line is rising, not falling.
An RSI line above 30 but below 40 could be a stock in an active downtrend, and that’s the last thing you want to own.
You also want to limit your universe of possible longs to stocks trading above the 200-day moving average, indicating they are still in a bullish longer-term trend.
Buy the stocks that are in a long-term bullish trend and have RSI reading that indicates they are improving from a short to intermediate oversold condition.
Set your stop loss or exit strategy immediately.
We are buying stock with momentum with this strategy, and if momentum turns, we want to be out as soon as possible.
The stock will eventually approach oversold levels.
How fast this happens will depend on the strength and speed of the underlying trend. I have seen this take days, and I have seen it take months.
If the trend remains up, it should eventually cross over the 70 RSI level and be overbought.
Once that happens, sell the strike right above the current price in the next month out from the current date.
Pocket the cash firm selling the call option and wait for your stock to be called away.
Set a trailing stop 10% below the point where the stock crossed the 70 RSI line.
If the stock drops to that price, sell the stock and buy back the option to take your gains in the position.
Using covered calls to exit trading positions can add those few extra percentage points of return that turn good into great.