Frequently Asked Questions
How much do I have to invest to get started?What if I don't have that much?
How do I get started?
What is "Bid" and "Ask" and why do I care?
How do I do it without your data?
How do I calculate yield?
How do I test the system?
Do I need a broker?
Where do I find info to check out stocks?
How do I know which deals to do?
How do I handle the stock price going down?
Can I really do this in an IRA?
Options are really risky, right?
Why do brokers let me buy on "margin"?
How much do I have to invest to get started?
The technical answer is that you can start with any amount. The practical answer is that in order to make maximum yields you probably need about $5,000. There are only a few brokers that will let you open a margin account for as little as $2,000. With small amounts of money, you must either limit the number of deals you do which increases your risk, or do only single contract deals with lower priced stocks which causes the commissions to take a larger bite out of your profits. You can usually do 5-8 contract trades for the minimum commission, depending on your broker.
You don't have to do this on margin so you could probably start with $500 but you would have to work very carefully to get started.
Go to top of pageWhat if I don't have that much?
Pool whatever resources you have with someone else or several people via an investment club until you make enough to go it on your own. You may have so much fun doing it together you will keep doing it that way. Just make sure you formalize the relationship since this is about money.
Paper trade until you are so sure of this system that you will find something to sell, someone to borrow from, a credit card you forgot about, a retirement account or insurance policy you can borrow from, or a better job.
Go to top of pageHow do I get started?
You have taken the first step. Start learning all you can about the Market in general and Covered Call Writing in particular.
Sign up for our student subscription or Investors Business Daily and start paper trading (see the FAQ "How do I test the system?") We would advise that you paper trade for six months before you use real money. In that time you will be able to track some likely stocks and get a feel for how their prices move. You should not trade real money until you have paper traded at least two deals where the stock price has gone considerably lower than what you purchased it at. You have be able to minimize your loses on those type of deals so that you don't panic when faced with the real problem. Anyone can do the deals that go smoothly. In order to be a successful covered call writer you must learn the damage control aspects of the profession.
Start slowly. If you are starting within a couple weeks of an expiration date, be sure to look at calls for the second month out. Since calls become worth less the closer they get to expiration there may not be many good deals available for the first month out. But sometimes there are, so don't ignore the near month. The first month is easy and you should be able to get good returns for all of your deals. That will build confidence and enthusiasm. The second month will be harder as you have to work with any stocks that are still left in your account. Just do your best and remember that your worst deals will probably yield more than you made all last year! Ways to handle deals that didn't do exactly as planned are added to these FAQs all the time so keep checking back here for ideas.
Go to top of pageWhat is "Bid" and "Ask" and why do I care?
Most, but not all, stock and option quotes will have a last transaction price as well as two other prices called bid and ask. The bid price is the price at which some buyer out there is offering to pay for the stock or option. The ask is the price at which some seller is offering to sell the stock.
To do a covered call you must first purchase some stock. If you are willing to pay the ask price for the stock, you transaction will usually happen very quickly since there is a seller offering it at that price. You can certainly place an order with your broker at some other price but it may never be executed. It is in your best interest to buy the stock as cheaply as possible.
Once you have the stock, you need to sell a call. If you are willing to sell at the bid price, your transaction will usually go through very quickly since there is a buyer willing to buy at that price. You can place an order at some higher price but the broker may never find a buyer at that price. It is in your best interest to sell the option for as much as possible.
Many covered call traders will buy stock when its price dips below its usual range and then wait for it to rebound so they can sell the option for more. That often works but we would encourage beginners to sell the option immediately after buying the stock to get the deal locked in at a yield rate near what they have been calculating on paper. Once you have been following some stocks for awhile you can experiment with waiting for the option price to increase. You will get to do that anyway the second month with the stock covering any calls that expired without being called.
Go to top of pageHow do I do it without your data?
Investors Business Daily and the Wall Street Journal and many local newspapers carry closing prices of stocks and options. The tables of prices are not sorted by best covered call yield as Sage Investors data is; in fact they don't even list a yield. It is up to you and your calculator to find the best deals on two pages of small print! And guess what? In two pages they only have part of the options. They will have some different ones tomorrow. Everyone should use the paper to start, as it will indelibly etch in your brain how to figure the yield so that you will not be lead astray by errors in the data of others, including us. Errors happen.
Go to top of pageHow do I calculate yield?
Brush off the old calculator. Yield is the money you make from a deal divided by the money you invest in the deal all expressed as a percentage. Example: we buy 100 shares of a $10 stock - 100 shares times $10 = $1,000 so we have $1,000 invested. We sell the call at $1.00. Since each contract is 100 shares, $1.00 times 100 shares = $100. So we make $100 on the deal. $100 divided by $1,000 = 0.1 or changed to percentage 10%.
If you do the same deal on margin, you will have $500 invested. $100 divided by $500 = 0.2 or 20% yield.
That was the simple approach to yield. A more complicated but more accurate way follows. When you buy stock you have to have the money in your account within 3 days. When you sell the option the money is in your account the next day. So if I buy 100 shares of $10 stock for $1,000 and sell the option for $100, and do it on margin, I will need to send in (or already have the money in the account) $900 which is therefore the amount invested. At the end of the month the stock sells for $1000 which means you made $100. $100 divided by $900 (your investment) = .1111 or 11.11%. Or 22.22% if you use margin.
The data files use the first method for simplicity and because beginners usually find it more intuitive. People have enough problem believing they can make these kinds of returns.
Go to top of pageHow do I test the system?
You test the system by paper trading or virtual trading.
The Chicago Board Options Exchange (CBOE) has a virtual trading tool at http://www.cboe.com/tradtool/virtualtrade.aspx. You can pretend to trade online as though you were actually doing transactions with your broker.
Paper trading is going through most of the motions and tracking hypothetical trades on paper. It is well worth the patience required to do it. Pick a starting date and an imaginary starting amount of cash. Use the newspaper or our data to find the deals that you think would work best and pretend to buy the stocks and sell the calls. You can either use real time quotes from an online service, quotes from cboe.com, or just use the closing prices in the paper.
Follow the transactions through to expiration and see what happens. If the stock price is at or above the strike price at expiration, pretend that you got called out and reinvest the money. If the stock is lower than the strike price at expiration, pretend you still own the stock and go sell another call.
See, it is easy and you will learn lots with very little cash out of pocket. You will invest some time but this may well be the most valuable learning time you have ever spent. You will discover this is why spreadsheets were invented. When you locate the broker you intend to use, figure in their commission structure so that you can see the impact that commissions have on your yield.
Once again, we recommend that you paper trade or use the CBOE virtual trading tool for at least six months and until you have survived two deals where the stock price falls substantially.
Go to top of pageDo I need a broker?
Yes. The system won't let you play without someone you can blame! Just kidding. By the time you get done filling out the paperwork to open your account with a broker, you will understand that they get blamed a lot but never take responsibility. It is your money and you are responsible for it. If you can't handle that, do something else.
Go to top of pageWhere do I find info to check out stocks?
Your broker is the entitiy with the fiduciary responsibility to give you correct data. Always check all the numbers with the ones your broker shows before doing a deal. On our data screens, both the stock symbol and the option symbol are hyperlinks. Clicking on the stock symbol will take you to whichever charting service is set up in your preferences file. The default is Ask Research so we will talk about their screens here. Other charting sites provide similar data and you can customize which service will be used when you click on the stock symbol. See the help button in preferences for details on customizing the charts.
When the Ask Research page comes up, you will see all kinds of data about the stock (including the last sales price) and the company that it represents. There will be a chart showing daily price changes for the last year. There will be data about many of the financial numbers for the company. There are hyperlinks to news about the company as well as a snapshot of data about the company. There is a chart showing how many shares sold each day and a chart showing something called the relative strength index. We cover how to use all this data in the separate menu item "Finding a Deal." Click your browser's Back button to return to the data screen.
When you click on the option symbol, you will end up at a Yahoo! Finance page which will show a variety of data about the option, including a slightly delayed (15 to 20 minutes) bid price. Click your browser's Back button to return to the data screen.
Go to top of pageHow do I know which deals to do?
Some thoughts on picking stocks follow but you should read the menu item "Finding a Deal" before continuing.
Don't do covered calls on stock you don't want to own. Companies with profits, good earnings, low debt are easy to pick - there just aren't many of them that have good covered call yields. Watch the ones that do have decent yields occasionally so that you recognize their dips and how long it may be before they will rally and the option will bring a decent price. You need some experience to buy on dips, sell on strength.
Ideally the P/E would be <= 20. There are good plays on stocks with higher P/E ratios but other things must fall into place. You can do deals on companies that don't have profits (no P/E} but they must have strong, increasing earnings or at least decreasing losses.
Don't play volitale stocks (ones whose charts bounce up and down a lot) at peaks, only as they come out of valleys. I would much rather play a stock in the bottom half of its 52 week range than in the top half. I will play a stock at the top of its 52 week range if it has climbed steadily over those 52 weeks with no major dips.
I like stocks that have recently split or are about to split.
Don't play stocks that will announce quarterly earnings before your expiration date.
Don't do biotech stocks that are about to get an FDA ruling. Biotechs are fine if the FDA approval is several months away. Providing the fundamental numbers are good in comparison to similar biotechs.
A 10% deal well in the money is safer than a 20% deal out of the money. In the money deals give you that cushion on the downside. In the money deals are the most conservative. Out of the money deals have higher risk and often more yield. One advantage to covered call writing is that you can dial in how much risk you are comfortable with.
Don't be in a rush to get your money invested. A 10% deal 2 weeks before expiration is much safer than a 25% deal with 5 weeks to go, especially with in the money deals. If you are doing lots of out of the money deals then the extra time may make sense. Don't get greedy. Shoot for 15% per month and laugh all the way to the bank with 10%.
Go to top of pageHow do I handle the stock price going down?
In the money deals automatically provide the cushion of the difference between the stock price and the strike price. That is why they are the most conservative plays.
The simplest method is to simply undo the deal if you see it going bad. You can buy back the option at any time and then are free to sell the stock also. If the stock price has gone down, both prices will be for less than the original deal. You are likely to lose some money but can avoid a large loss. It is best to have fixed in your mind the stock price at which you will undo the deal before you buy the stock to start with. Think the deal through and then stick with your exit strategy. This is especially important for beginners.
Sometimes the price of the stock is going down but you expect it to come back up, just not before expiration. In that case you should buy the call back when its price goes down and roll into a call the next month out. That way you buy an extra month for the stock value to recover. You may make enough on the first call to reduce the cost of the stock enough that you can sell the next lower strike price.
If you save some money for later in the month you can sometimes lessen the impact of your losers by "doubling down." I'll illustrate with a deal I did in January 1996. I bought 200 shares (must have had a premonition to buy so few) of WSTL at 20 3/8 (in 1996 all prices were still given in dollars and fractions) and sold 2 Feb 20s for 2 1/2. When the price fell to 15, I bought back the Feb 20s for 1/2 and bought 200 more shares which moved my basis in the stock to 17 11/16. A couple of days later I sold 4 Mar 17.5s for 1 5/8. I had given myself another month for the stock to come back around. If called out at 17.5 I would make about 15% per month. The stock continued on down to 13 1/8 where I bought 400 shares. My basis was now 15 7/16. On a rebound to 15, I sold 4 Mar 15s at 1 1/2. If the stock had made it back to 15 by March expiration, I would have gotten called out of 400 shares and sold the other 400 and made 10% per month on a stock that went down 25%. I could sell at 13 3/8 and break even. This stock eventually went below 11 and then rebounded and I sold out at 15 in late March (after expiration).
Go to top of pageCan I really do this in an IRA?
Yes, just not on margin.
Go to top of pageOptions are really risky, right?
So is crossing the street. Buying options is riskier than buying stocks because they have a limited life. When we sell calls that works to our favor. Covered calls are the least risky option strategy. Many investment advisors don't like them because they have locked in your return if the stock makes a large gain. We say lots of small gains are better than a few large gains. That is why we play the shortest time possible, take the money and do the next deal.
Go to top of pageWhy do brokers let me buy on "margin"?
Because they charge interest for the use of their money. When you use margin to buy stock, you are really just getting a loan from the broker. If you are the type that would not dream of borrowing the money to start your account, you probably should not buy on margin either. If you have used all the margin in your account (a bad idea unless you have ready cash elsewhere) and one of your stocks takes a serious downturn, you will get a margin call. Your broker will ask you to add enough money to your account to get your equity in the account back up to 50%. If you don't the broker will sell off whatever it takes to make it so.
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