Selling Covered Calls is a very simple approach to trading options for both beginners as well as professional traders. The risk to the downside is mitigated by the sale of the call option and upside risk is eliminated altogether, because the seller is long the underlying asset.
In this tutorial I’m going to show you a step by step approach to writing covered calls utilizing a combination of technical indicators and implied volatility; so that we can increase the odds of collecting as much premium as possible and at the same time decrease the risk of being stuck in a stock that will decrease in value over the next few months.
Unfortunately, the majority of the time, I find traders focused entirely on technical analysis or options Greeks, but rarely both; and in my experience using one and avoiding the other is one mistake you want to avoid.
The first step and the most important step is to identify the right asset
Finding the right asset when writing covered calls is very important because statistically, there’s a good chance that you will end up keeping the asset and an even greater chance that the call you sell will expire worthless. So you have to find stocks that are trending strongly and merely taking a pause, before continuing in the direction of the trend.
Financial markets tend to go through two main cycles, the trending cycle and the range bound cycle and you will find that these cycles rotate back and forth. This makes sense on different levels, because financial markets cannot generate sufficient momentum to move in one particular direction for extended periods of time and need to to create balance or equilibrium between buyers and sellers before starting another trending cycle.
In this example, you can see how Facebook trends for a few months and then begins to move sideways. One way of identifying the end of a trending cycle, is when the asset increases volatility but at the same time begins to lose directional bias.
The next and equally important step is to make sure that the underlying asset is exhibiting high level of implied volatility. If the implied volatility is high in the underlying asset, then the options implied volatility will also be on the high side and we will receive higher premium for the risk that we will assume when selling the calls.
Looking at the implied volatility chart below, we can see that current levels are at highest levels seen in several months, even higher than the last two peaks. Notice that volatility moves up and down very quickly, so it’s important to constantly monitor implied volatility levels on stocks and other assets.
Since implied volatility levels in the underlying asset are very high, I now want to check to make sure that that I find the best option, one that will give me the lowest risk and at the same time offers enough premium to assume the risk of having the stock move lower, decreasing or possibly eating away at the premium that I receive on the trade.
Considering all the different options, I want to make sure that implied volatility levels are high and equally as important, I want the option to expire as soon as possible, so that I can keep the premium and at the same time have no obligation to the call buyer.
As you can see by the chart above, implied volatility can play a huge role in the price of the option. The 96 call that expires in 10 days is priced at $3.90, while the same strike price call option that expires in 24 days is valued at $4.45.
The reason why the call that expires August 7th seems expensive when compared to the call that expires on the 21st, is due to implied volatility being substantially higher on the near term option, in comparison to the call that expires on the 21st of August.
The implied volatility on the 96 strike price call option that expires on the 7th of August was at .677, while the implied volatility on the 96 strike price call option that expires on the 21st of August is only .483 at the time the option was sold.
When selling covered calls, you want to gain as much value in as little time as possible, so that your obligation to the buyer to sell him the shares will be as limited as possible. Therefore, I recommend you sell call option that have the least amount of time till expiration, while at the same time bringing in substantial premium into your account.
After considering the different call options, I settled on selling the 96 strike price call that expires in 10 days, since it offers me the highest level of implied volatility as well as the least amount of time till expiration.
The stock continues to stay in a range bound cycle for the next several trading sessions and finally settled below $96.00 the day the option expired, so we got to keep the stock and the entire premium that was received at the time the option was sold.
Keep in mind, I utilized very simple technical analysis to help me identify the correct asset and the overall timing. And at the same time I took into account the Greeks to make sure that I was selling calls that had high implied volatility levels, so that I would receive the highest premium possible in exchange for incurring my obligation.