Here is a question I received recently from Lee, he asks:
“Over the weekend I’ve been reading about covered calls and honestly it doesn’t make much sense to me. It seems like a lot of waiting around for very little money…..am I missing something here?”
When I started trading I had no idea what I was doing. I come from a background of hard work = results, so just sitting on my hands doing nothing during the trading day was impossible for me.
I would enter a position, then it would go against me a little bit, so I would adjust immediately, then get bored with this new adjustment so I would adjust again, etc. Commissions would eat up my account and my portfolio went nowhere.
I had two huge problems:
- Adjusting my positions too quickly because of nerves or boredom.
- Not seeing the “big picture” of how income trading produces results over time.
It quickly became my goal to “flip” my strategy into the opposite way of thinking and actually let the position work itself out. I began speaking to other income-type traders and here are some of the things they told me:
“If you are selling premium, you need to put it on a schedule - much like renting out your house - sell a specific amount of premium per month/quarter or whatever. This is your job”
“Don’t stare at your positions more than just a few times a day. It’s either on-track, or it’s off-track based on pre-defined price levels. Don’t adjust unless it’s off-track - ALWAYS HAVE A PLAN BEFORE YOU EVEN THINK ABOUT GETTING IN A POSITION.”
“You can’t think about missed profits if the stock runs to the moon, rather, you need to think everyday about selling enough premium to reduce your cost basis on the stock - that’s the whole idea”
This was liberating. I chose to listen to these traders because they were making money and I wasn’t. Also after implementing their suggestions, my stress level decreased - giving me more energy and enthusiasm which helped me to allow these positions to grow over time.
Years later, when I started coaching newer traders, I saw these same misconceptions or
myths keep cropping up with them.
Here are the myths that I hear all the time from newer traders:
MYTH 1: Trading is all about pushing buttons and being stimulated every single second, or it’s not working. (i.e. Massive action = better results).
TRUTH: Never make any trading decision based on your lack of activity. If the day is slow and you don’t need to adjust anything, then go take a walk. I often set alerts through my trading platform at certain price levels and have these alerts forwarded to my phone. This allows me to have a little bit of freedom throughout the day to prevent me from staring at the screens.
MYTH 2: Your profits are capped at a certain amount with covered calls, so if a stock really runs, you will miss out.
TRUTH: Would you rather make consistent gains that are capped, or wait impatiently until you hit that one home run on a stock which shoots to the moon? I choose consistency. And who says that you can’t cover (buy back) your Call on the stock temporarily if you are expecting a big move? Again, if you’ve worked down your cost basis (see below), then this becomes a possibility.
MYTH 3: You must have hard stops in place always.
TRUTH: Well, hard stops are sometimes necessary, but not really necessary if you work down your cost basis on the stock. This means that if you sell enough premium over time, the stock will have plenty of wiggle room before you actually take a loss.
Today I will show you how you can destroy these myths and use some simple methods which will help you think differently about using covered calls in your trading arsenal.
THE STRATEGY OF WORKING DOWN YOUR COST BASIS
“What do you mean by reducing my cost basis on a stock?”
If you ask a random person on the street, how do you make money in the stock market? They will most likely answer: “Buy low and sell high!”. Yes, this is true, but how often can we pick winning stocks which go straight up?
Here’s another way go about it: While I’m waiting around for the “big move” UP, why don’t I sell option premium to work my cost basis (the amount of money you paid to buy the stock) DOWN. Make sense?
If I do this successfully, I will have enough “padding” on my position to where I don’t care so much if the stock goes down or wiggles around.
For Example: Today $WYNN got juiced by some analyst upgrade and rose 6%.
Pretty nice move - but I don’t really care so much about this initial pop in the price as much as I care about the Call option premiums exploding. I’m looking at the April 95 Calls for $3.00
So the 95 Calls in April are now worth 230% MORE than they were before some analyst gave their opinion. LOL. ok.
Here’s the plan:
Much like chess, trading is about thinking several moves ahead. I know that if I sold these calls against my starter position in the stock, that I am protected $3.00 below the price I paid for the stock. So right now my padding is down till $91.47 (94.47 minus
3.00 in option premium I sold).
Now what happens if the stock falls below an uncomfortable level?
Well, I buy BACK the 95 Calls and sell some a bit lower, or farther out in time, or both;
i.e. collect more premium. ALWAYS working my cost basis lower.
What happens if the stock rips even higher?
You could let the stock get called away, OR roll your calls UP and OUT in time. Selling the same amount of premium somewhere else.
Keep in mind, these are just TWO of the ways we could deal with the position. There are many other advanced strategies such as the following:
- ON AN UP MOVE: Rolling the calls up even higher and financing the rest by selling
- ON A DOWN MOVE: Since we’re in a starter position, we could acquire more stock and sell more calls, reducing the cost basis even more.
- MAKE IT A SET-RISK POSITION: We could morph the position into a Bull Call Spread and have limited down side, then not worry about adjusting it at all.
HERE IS WHY THIS WORKS SO WELL
In trading, rarely do want to set yourself up to be at the mercy of only ONE outcome. Much like these older, more experienced traders taught me, you want to remain flexible enough to have a solid plan BEFORE you enter a position and be prepared to admit you are wrong and adjust according to your plan.
So, the way you can be more flexible is learning how to finance (working down your cost basis) on the position by selling premium as well as selling premium to finance your adjustments to the position.
This is a formula for long term growth. It requires patience, practice and planning to be successful. It can also be abused by over-adjusting too. So be mindful of this.
In the comment section below, tell us:
- Have you had experience with some of these strategies?
- What is your process in “pre-planning” a long term trade, like I’ve mentioned?
- What are some techniques you’ve used to control “boredom trading” or anxiety?