Option Investor

Covered-Calls 101

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Reflections on Strategy Selection & Position Management

The great thing about trading "covered" calls is almost anyone can become an expert with this strategy, even with very limited experience in options trading. On a relative basis, it doesn't require much time because once the position has been initiated, you can place closing orders at key technical points in the price range of the underlying issue, or you can watch the stock for changes in trend or character, using a mental stop to signal exit trades. Of course, losses will occur, despite the fact that the strategy is conservative, and a painful lesson will transpire the first time you delay your exit from a losing position. After you have been around the options market for awhile, you will soon learn that it doesn't matter what method you favor, losses are simply part of the game. One problem that new traders must overcome is learning to close losing plays early, while the capital drawdown is still relatively small. The simple fact is, there is no good reason to stay in a losing trade when there are so many other viable plays that deserve your time and money. I've said this before but it bears repeating: The best (and most profitable) solution is to accept your losses, learn from your mistakes (and evaluate each one critically), then move on! Success will not come immediately so you must have patience and continue to work hard, learning the fundamentals of the options market and gaining skills that other profitable traders exhibit on a daily basis. Indeed, too many new investors give up after a few losing plays, long before they have time to learn (and absorb) the various methods required for profitable trading.

Once you understand that losses are simply part of doing business, you can move on to the "nuts and bolts" of position management. With covered-calls, the key to success is keeping losses to a minimum because there are never any big winners to offset the big losers. That is also why correctly managing your positions is one of the crucial requirements for achieving consistent profits with this strategy. As we all know, successful traders have a number of common traits and by the same token, there is a reason why the majority of people lose money with options. Most of them have yet to learn the #1 secret of profitable trading: The market will always prevent the uneducated masses from making money while consistently rewarding the astute professional minority. If this is the case (and I assure you it is), the first prerequisite for long-term success is knowledge. Buying and selling stocks may be a simple technique but when you add options to the mix, the game becomes much more complex. A trader must completely understand any strategy being used, including its advantages and weaknesses, before using it on a regular basis.

Obviously, you can't make good decisions without knowledge of the mechanics of a specific technique and the most successful traders are those who are acutely aware of how best to overcome the shortcomings of their particular approach. Since limiting losses is a major goal for covered-call writers, it stands to reason that every position should have a predetermined exit point. The majority of market professionals use protective stop-loss orders with their positions but the retail trader is far less proficient in this practice. Using stop-loss orders eliminates the risk of emotional or reaction-based judgments in difficult situations and removes fear, hope and greed from the entire equation. The consistent use of stop-loss orders also provides a mechanical and disciplined method for achieving profits. Statistics prove without a doubt that allowing the market to make the exit decision is much more precise than relying on our complex human intuition.

Just as setting stops on each individual position is an absolute must, a maximum allowable loss must be considered when managing portfolio positions. The rule here is simple: Never trade with more money than you can reasonably afford to lose and always maintain a reasonable cash reserve. When establishing the position size and collateral requirements for your portfolio, ensure that funds for active trades are not co-mingled with capital for other functions. It is also very important to set a "loss limit" at the beginning of each month or option expiration period. When this level is breached, trading should be halted for the duration of that period. Of course if your losses are consistently more than your gains, stop trading! Step back and take a few days off. When you are ready to try again, evaluate your current approach and review the steps that will be taken to avoid losses. When you begin to make money, put some of the profits in a reserve account, just in case there are any unexpected developments in the future.

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