3 Trading Scenarios

Now that we have looked at some stocks that might be good candidates for covered call strategies, lets think about how we trade covered calls day to day. The three basic reasons that people use strategies such as covered calls. The first is to increase the rate of return on current stock investments and give some downside protection with the generated call premiums. The second is to generate longer term wealth accural, such as an IRA. The third is to generate monthly income. Over the next three days we will discuss options on how to best trade for each of these scenarios.





In the first scenario you can write options on stocks that you have owned for a length time. Generally they are blue chips. Writing covered calls on these is not going to generate a tremendous return, but if your goal is to hold blue chip stocks for long term gains you can add 8-10% per year. The key is remembering what the goal of this and each of the three strategies is. In this case, the goal is long term appreciation of the stock. You will have to determine option premium versus stock price increase versus short term trend for the stock price.





Lets take Wal-Mart as an example. As of close on friday the stock was at 49.44. The short term outlook for the stock is bullish (above 50 day moving avg, relative strength indicator is rising). The 50 march option is at 1.40. The 52.50 is going off at 0.55. If you think of the options premium at an addition to the strike price of the option, in this case 50 +1.40 =51.40. So if you don't think the stock is going above that with the next 30 days, it would be best to sell the 50 option. You would get the stock increase up to the strike price, 50 in this case. Using the 52.50 option, your defining price would be at 53.05.





The other benefit to consider is the average price of the stock. In the 50 option scenario, it is 49.44 - 1.40 = 48.04. The average price that you have in the stock is 48.04. If you are in the market to hold blue chip stocks for lock term appreciation this can be very important. In overall bear markets, if you hold the stocks until the market turns around, you can lower your average price and increase your profit long term.



Covered calls can be a nice addition to this type of portfolio. It will take a little analysis to understand when to write that closet option versus a farther out option. It will take a little more work, but it will be worth it. Tomorrow we will talk about scenario number 2.



Talk to you tomorrow.