Saturday, June 11, 2011

Covered Call Rules

I've added covered calls to my quiver of strategies. Here's a formal write-up of the rules for covered-call positions.

A full description of all of my trading strategies is in the essay "How I Trade" linked to from the menu bar at the top of the page.

Covered Call Plays

For covered call plays, I want to own shares in companies that are rising or trading sideways,

The nature of covered call is that they limit profit, so I’m not particularly interested in stocks that are in the midst of a steep rise. Those plays are covered by the price channel strategy.

In selecting potential covered calls, I use the same 55-day and 20-day price channel structure, and the average directional index (ADX), as I do for price channel breakouts. However, I use them differently, and I also add in the MACD -- the moving average convergence-divergence indicator -- as an additional tool to judge the state of play on a given stock.

All covered call positions are bull plays. I select stocks that have bullish financials, the more bullish the better.

Here are the rules:

  • Is the stock in neutral or bull phase?
  • If yes, then is the stock trading above the lower boundary of the 20-day price channel?
  • If yes, then is the ADX less than 25?
  • If yes, then is the MACD above zero?
  • If yes, then enter the position.


Covered calls are exited through a stop/loss calculated as follows:

  • Calculate the breakeven point of the position: The stock entry price less the premium received from the sale of the call.
  • Calculate the 2x average true range (ATR): Multiply the 14-day ATR by two.
  • Set the stop/loss at the breakeven point minus the 2x average true range.

Generally, this gives the price plenty of room to move in the 20- to 30-day lifespan of the position while offering protection from large losses.

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