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Covered Call Writing Strategy - For Compounding Monthly Income

You may have heard that the best covered call writing strategy is ideally suited to stocks which have good fundamentals and are on the rise. Let's assume you have adopted a strategy to write "out of the money" call options immediately after purchasing multiples of 100 of any U.S. 'optionable' stocks. There are 3 possible outcomes:

1. The stock remains below the strike price but doesn't fall significantly, by option expiration date- AVERAGE OUTCOME ... you keep the call option premium and possibly make some gain on the shares if you choose to sell them

2. The stock is above the strike price at option expiration date- BEST OUTCOME ... you keep the call option premium PLUS enjoy a gain on the shares if and when you are called to sell them

3. The stock falls significantly below the strike price by expiration date- WORST OUTCOME ... you keep the call option premium and use it to offset the loss on the shares

It will be obvious from the above, that our most favourable covered call writing strategy would be to sell call options at a strike price above our purchase price for the stock, then enjoy the satisfaction of selling the shares for a gain within the near month expiry period of the options. Then just do it all again . . . .

You can still make a monthly income using another covered call writing strategy suited to a bear market. We will consider that in another article. For now, let's focus on picking stocks that are most likely to either rise or remain in a tight trading range in the near term.

To do this, we need to be aware of a couple of positive technical indicators. The first is the 50 day Exponential Moving Average (EMA) in connection with the 200 day EMA. When the 50 has crossed above the 200, this is generally considered by the charting world to be a sign that the stock is experiencing a "bull run" trend and tells us that the covered call writing strategy we should be interested in, involves writing "out-of-the-money" ... "at-the-money" or slightly "in-the-money" calls - depending on the percentage yield each alternative offers us.

We want a call option premium which is at least 10 percent of the current market value of the underlying stock. If we can get this using out-of-the-money options we will be happy, otherwise look at 'at-the-money' etc.
We prefer options with a higher than normal Implied Volatility, but not at the expense of positive stock fundamentals.

In order to apply this covered call writing strategy quickly, a good covered call screener would help to bring up relevant data. The "options dragon" at OptionsXpress is an excellent free tool in this regard - but you have to be using them as your broker to access it. Having located stocks where the 50EMA has crossed above the 200EMA, you then draw trendlines over the top and bottom of the 'highs' and 'lows' to get a feel for where your stock is in its trading cycle. This will help you with timing of your entry. If the 50EMA has crossed below the 200EMA, you should consider a more conservative 'bear market' covered call writing strategy. We will outline these later. You should also look at the RSI technical indicator and determine whether the stock is near the upper (70) or lower (30) area. If above 70 it may be "overbought" and you should stay out. But if near the 30 "oversold" level this is a good indicator of future positive movement.

But back to rising stocks ... we want to stack the odds in our favour for a near term positive stock movements even more. A great tool to use is the Investor’s Business Daily service. It is limited to the USA stock market and although there is a monthly membership fee, the analysis they provide will reward you ten times the cost.

This is what you do - membership with IBD will allow you to use their IBD Power Tools to scan the entire U.S. market for stocks with an 'Earnings Per Share' in the top 25 percent of all stocks trading on U.S. exchanges. You include in your search criteria, a 12 month Relative-Strength Ranking in the top 25 percent (not to be confused with the RSI indicator here - it's IBD's own terminology). These two important fundamental performance indicators, together with the technical indicators mentioned above, will ensure confidence in your covered call writing strategy.

Having established all positive indicators for your chosen stock to either rise or remain neutral during the near month option expiry cycle, you then check that the premium offered will meet your yield criteria and if acceptable, place the 'buy-write' trade. There is great advantage in using only 'near month' option expiry dates over 'later month' ones. During the last 30 days of an option's life, it's 'time value' declines at an exponential rate. Since you are a "seller" not a "buyer" of call options, you want to take advantage of this.

So ... to summarize your best covered call writing strategy:

1. 50EMA to be above 200EMA if trading aggressively (per this strategy) otherwise trade conservatively.

2. Call option premium at least 10 percent of current market value of underlying stock

3. RSI technical indicator does not indicate "overbought" at time of entry

4. High implied volatility is good, but not at the expense of positive fundamentals. Stay away from tech stocks and drug companies - they are too unpredictable.

5. To add that edge of confidence, use the Investor’s Business Daily Online service to scan the markets for (a) EPS in top 25 percente of all U.S. stocks, and (b) their Relative Strength Ranking in the top 25 percent also.

If all the above features come into play, there is but one thing left to do . . . . . GO FOR IT!