When choosing covered call prospects, I first want to have some opinion about where the market will be when the options expire. Since no one can foresee the future, it is generally a fruitless activity. Even so, it helps me make the basic decision about choosing covered calls: How far should the option strike price be from the stock purchase price, and in what direction?
The rule of thumb for traders is to sell in-the-money calls in a down market, out-of-the-money calls in an up market, and at-the-money calls in a sideways market.
To form my opinion of the market's course, I look at several things: The leading economic indicators report, the volatility of the S&P 500 (the VIX), the 40/10- and 200/50-day moving averages on the S&P 500, and the index's support and resistance levels. I give greatest weight to Elliot wave analysis, as done by Robert Prechter and his team at Elliott Wave International.
(To learn about Elliott waves, read Prechter's book Elliott Wave Principle: Key To Market Behavior. The Elliott Wave International newsletters are excellent.)
(It would be an interesting study to determine market direction and strength by a roll of the dice, and see how that affected trading results.)
All in all, I'm slightly bearish the market, but not with a lot of conviction and I don't expect a huge decline. So I'm going slightly in-the-market with my strikes, but not as far as I did for the October positions.
I select my strikes as a multiple of the 10-day average true range (ATR), which measures how far the price of a stock moves each day. This gives me an adjustment to match the volatility of individual stocks. For October I was bearish and went four times the ATR in the money. For November, at present, I plan to go two ATR in the money (and Monday's trading might alter that opinion).
For November, I'm selecting from a universe of stocks with average volume of 5 million shares, a price of $15 or greater, return on equity of 15% or greater and a near-term rating of hold or better from the analytical house Zacks.
I've eliminated stocks with earnings announcements 20 days or less from the last trading day, which is Nov. 18.
The result is 18 stocks. Their premium returns range from 15% to 10%, and their if-exercised returns are all 2%, 3% or 4%.
The stocks are, in descending order of the premium percentage: CLF, BIDU, HAL, FCX, WYNN, LVS, UAL, MOS, HPQ, STX, DFS, JBL, POT, SWN, CAT, AFL and VALE.
BIDU has the highest if-exercised return, at 4%.
CAT announces earnings on Oct. 24; AFL and VALE on Oct. 25; and CLF, BIDU, WYNN, LVS, POT and SWN on Oct. 27. I'll wait until after the announcement before opening a position.
Also, some of these shares go ex-dividend during the November options period: WYNN on Oct. 31, and MOS, STX and JBL on Nov. 1.
In addition, this month I'm looking to add some exchange-traded funds (ETFs) to the mix. They generally have lower returns than individual stocks, but they also are harmed less by earnings surprises and other black-swan events; the pain is spread because most are already diversified.
That diversification also means I can put more money on a single position, reducing the total number of positions in my portfolio and making them easier to manage. (Span of control is always an issue in trading, unless you have a vast staff of minions on your payroll.)
For the ETFs, I looked at the top-volume offerings, and then selected those having the highest premium returns and if-exercised returns greater than 1.5%. I excluded bear funds and funds having multiples of the underlying.
The dozen ETFs that made the cut, in descending premium-percentage order: XOP, SLV, XLF, EWZ, IWM, FXI, GDX, USO, XLB, EEM, KBE and XLE.
The premium return ranges from 12% to 8%, and the if-exercised returns are 3% and 2%.
Finally, I have one lone holdover from October. The covered calls on GMCR were not exercised and expired worthless, leaving the shares in my portfolio to cover more calls that I shall sell.
Holdovers present a tricky problem. They are held over because their prices fell. Most likely, the current price is below what the trader paid, and if future covered calls are exercised at that lower price, it could wipe out profits from earlier months. So my strike selection will need to consider my basis as well as the factors I'm using for new positions.
That's the lot. I'll be making final decisions and placing trades this week, and shall report my holdings in the daily Covered Calls report.
About my trading methods
Read a detailed explanation of my analysis method, including trading rules.
Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.
The trader’s greatest sin is inaction. Sleeper, awake! Seize the Nietzchean moment. Roll out of bed and trade.