10 Buy-Write Rules to Follow

Investors using the covered call option trading strategy own the underlying stock and sell one call option for every 100 shares held. The option premium garnered can be a nice addition to any gains realized in the stock. This strategy is referred to as a buy-write when the investor buys the stock and sells, or writes, the option in a simultaneous trade. The strategy has proven to be a smart way to gain income on your stock positions. To that end here are a few tips to help improve your call-selling results.

Note: these tips are mostly aimed at people who buy stock for the purpose of writing call options.

Call Writing Tip #10: No earnings release dates before option expiration

Stocks are extra volatile just before and after an earnings release date. While that volatility can make for attractive call premiums, you don’t want the underlying to drop 20% overnight because of bad results or poor guidance.

Call Writing Tip #9: No biotechs/pharmaceuticals

When there is an FDA announcement these stocks tend to get cut in half or double overnight. In either scenario, covered calls are not the best strategy to take advantage of that kind of volatility. If you’re going to take the risk then why put a cap on your upside by selling a call option?

Call Writing Tip #8: No leveraged ETFs

Leveraged ETFs, which use two or three times leverage to magnify the results of an unleveraged ETF, are mostly day trading instruments not designed to be held over night. Not appropriate for covered calls.

Call Writing Tip #7: No thinly traded stocks

Large volume in the underlying stock makes for small spreads. The opposite is also true — thinly traded stocks and options have large spreads. These large spreads will hurt you if you need to exit your position early or make an adjustment to your position. Better to stick with highly liquid stocks, or at least avoid the illiquid ones.

Call Writing Tip #6: No options with low open interest

Similar to Tip #7, you don’t want to be in an option series that has low open interest. If you ever need to exit early you are unlikely to get a fair price in a series with low open interest. The series should have at least 2000 open interest, but as little as 1000 may be okay.

Call Writing Tip #5: Don’t chase highest return without knowing why

It’s easy to find the highest yielding buy-writes but those need to be viewed with an inquisitive eye. Why are those options priced so high? Is there some pending news announcement? Or is the stock a momentum play? Or a short squeeze? There’s almost always a discoverable reason for fat premiums and you want to make sure you know what it is before getting involved. Do your research.

Call Writing Tip #4: Dividends before option expiration are good

If the stock is going to pay a dividend then why not set yourself up to receive the dividend as well as the call premium? Look for ex-dividend dates before option expiration. Be aware, though, that IF there is very little time premium remaining in the option on the day before the ex-dividend date THEN you may be subject to early exercise.

Call Writing Tip #3: Position sizing is important

Don’t put all your eggs (or even 25% of your eggs) into a single investment. If you have a small portfolio, try to limit each position to no more than 10% of the portfolio value; larger portfolios should target no more than 5% in a single position. If you can’t meet those goals then consider doing buy-writes on diversified ETFs which have built-in diversification.

Call Writing Tip #2: Diversify

Don’t put all your buy-write trades in the same industry sector. Spread them around to different sectors to avoid too much correlation and sector concentration. And, again, if your portfolio is on the smaller side then consider broad-based ETFs, a basket of stocks, and remove much of the single-stock and single-sector risk.

Call Writing Tip #1: Be prepared to own the underlying stock

Even the best laid plans sometimes don’t work. If you’re selling short-term in-the-money (ITM) or deep ITM options with the expectation that they will be called away, realize that they may not be called away. You may end up owning the stock after expiration. If you’re not comfortable with owning the stock, then choose a different stock for a buy-write.

This article is by Mike Scanlin, CEO of Born To Sell, www.borntosell.com, a web site dedicated to helping people earn monthly income from selling call options.