How Covered Calls Turned a Trader Around

Sidney felt sick as she looked at her latest OptionsXpress trading statement. In just 8 months, she had managed to turn her $120,000 account balance into less than $70,000.

Tears welled up in her eyes as she realized that the financial freedom she so desperately sought was slipping uncontrollably out of her grasp. For the first time since the accident, she felt desperately fearful of the future.

How would she be able to keep custody of her two young children, Paul and Sara, without an income once the money was gone? She just knew her violent ex-husband, Tom, would file for custody as soon as he discovered that she had no way of providing for her children, and then she would be on her own. Her situation seemed hopeless...

12 months earlier, she had received a compensation payment for a work related accident and at the time had no idea of what to do with the money.

Her injuries were so severe that the likelihood of her working again in the near future was slim at best. She needed financial advice, but who to turn to, she had no idea.

A well meaning friend had mentioned an options trading course he had attended and suggested that trading might be a way for Sidney to earn above average returns on her compensation payment money, as interest and dividends would not be able to provide enough income for the family to live on.

She thought about it for several weeks, $5000 was a lot of money to put up to learn something that seemed totally foreign to her. Her other friends, when asked for their advice, warned her not to even consider options trading - it was a casino and everyone who ventured there lost their shirt.

The thought of extra returns however was too much for her, so she signed up for an upcoming course and hoped she could learn enough to succeed where so many others had failed.

The weekend course came and went in a blinding flash of trendlines, moving averages, support and resistance and Bollinger bands. She didn't know what had hit her.

At home the following day, she sat and stared at the course materials and was more confused than ever about options and spreads, puts and calls.

She looked at her two young children as they slept peacefully and decided that she simply HAD to get this right - she could see the potential - the course presenter had shown them trading statements showing profits of up to $25000 on a single trade, and no losses, so it was possible.

For the next two weeks, she read and re-read the course notes and listened to the CD's of the event she had received in the post after shelling out another $1400 at the seminar for them.

It finally started to make some sense for her one Saturday afternoon when her seven year old daughter looked at the chart she had on her computer screen and said, "That line is going up, Mommy, what is it?"

She looked into her young child's eyes and smiled, thinking "How simple was that?" She had just written out a trading plan for a put option trade based on her analysis of that very chart - she thought the price would go down; how wrong would she have been?

She stared at the chart for several long minutes and then she saw it.

She had been told that the safest place to buy put options was on the first lower top - at the start of a downtrend. However, she also had been told to place a 30 day simple moving average on the chart and never to trade against the direction of that indicator. The Stock had made a lower top, but the trend was still up.

These two conflicting filters had confused her until now. She re-read her notes and found that she must never trade against the direction of the 30 day moving average.

She felt like she had discovered the Holy Grail of trading.

She went back over her charts and looked at the 30 day moving average on each one - in all cases, that had been the trend direction and it just kept going - she had been trading against the trend! If she went with it she would be raking in the profits in no time.

Armed with this new insight, she decided that she would take the next trade that presented itself with real money and she was sure she was on her way.

The opportunity duly presented itself. She bought 10 (no use starting small) MSFT (Microsoft Corp) July Calls for $1.12, a total outlay of $11,200 plus commission.

The Stock promptly fell for three days straight. She panicked and sold the options at what turned out to be the low of the third day for $0.38 cents - a loss on her first trade of $7500! She was shattered. The next day, the Stock rallied and within two days it was at a new high for the move.

What had happened? She had sold at the very low of a reaction to the main trend. How could she have been so stupid?

She watched as the option premium quickly rose to $2.14 without her. This movement consumed her completely and she didn't even bother looking at her other watchlist Stocks - she was mesmerized by the one that got away.

The Stock continued to climb, as did the option premium - $2.85, $3.41, $3.82. Each day she watched as it doubled, then tripled her original stake. She cried - why?

It seemed the trend was going to continue forever, so she decided to get over it and buy some calls at the bottom of the next 3 day reaction - yes, that was it.

The Stock was having reactions of 2 and 3 days, so at the end of the next one, she would buy calls and make her lost money back.

That week, the price of MSFT started to come off a little, and had three big days down.

She bought 20 MSFT calls (well she had to get her money back, didn't she?) at a much higher strike price than the last ones and paid $1.31 for them, expecting the rally to come the next day.

Overnight, the US market fell 4% after terrorists attacked a Government building and threatened more similar attacks in the weeks and months that followed.

Sidney woke up to see the carnage in the US Stockmarket and just knew it was going to be a bad day.

MSFT opened down $1.30 along with the general market. Her call options were bid at $0.40 cents.

She remembered the last time this happened - she had sold in a panic. This time, she decided to hold on for a better price. The Stock continued to fall. The rally never came this time - the season had changed in the Stock Market.

Sidney held those options all the way to expiry - to zero, because she didn't have the stomach to take another loss like the last one. In two trades, she had lost over a quarter of her compensation payment. Things looked grim.

Her trading continued on for the next few months in much the same way. Small profits, large losses.

She frequented the trading forum of the group that had held the seminar but couldn't find any answers there either - most of the traders who posted comments were in the same boat.

Her friends kept saying "I told you so!" so she stopped hanging around with them. She was consumed with getting this thing right and nobody was going to stop her.

Then came that fateful day when she opened her monthly Options Account statement and saw the account balance had dipped below $70,000.

She wept uncontrollably for hours that day. She had failed. Her kids would be taken away by her ex husband and there was nothing but black for as far as she could see into the future - her life looked bleak.

In the midst of this horrible experience, her 12 year old daughter came home from School and found her mother in tears. "What's wrong mom?" her daughter asked. "Oh, this option trading will be the death of me darling," Sidney sobbed.

"Why, what's happened?" Sara asked. "Every time I buy an option, it goes down in value," her mother answered. "Who do you buy the options from, mum?" Sara asked after some thought. "Other traders," Sidney answered.

Then Sara said the most profound thing Sidney had ever heard a child say, "Mom, it sounds like those other traders are getting the best deal, and you are getting ripped off. Why don't you do what they do?"

Sidney was about to explain why she was an option buyer instead of a seller, but stopped mid thought when she realized the power of what her daughter had just said.

Of course, every option that she had ever bought and then sold at a loss had made a profit for the seller, at her expense. She was speechless...

She had to change her strategy - immediately! She would become a writer of covered calls and sell options to others.

The next day, she went to the library and found three books on option writing and studied them cover to cover. It was simple...she would become an option writer and take the profits from the punters expecting extraordinary profits that rarely came.

To do this, she would start buying Stocks and writing covered calls over them. But which ones. She studied the pages of Investors Business Daily, looking for the options with the highest volatility, because she knew from her studies that she had to sell high volatility options to get good premiums.

She also wanted a low Stock price so she could buy more than a couple of thousand of them to minimise the effects of Brokerage fees on her profits.

The US options market appeared to be a goldmine for sellers because so many Stocks tended to hold strong trends, while still offering good premiums for their options - apparently many traders expected the trend to change every day, therefore bidding up the prices of options that were clearly not going to make them a profit if the trend continued - Sidney would use this to her advantage.

After careful study and several weeks of research on the Internet, Sidney chose one Stock to focus her initial attention and looked for a buy point.

Please Note - the following example is for illustration purposes only and does not constitute a recommendation to buy the Stock mentioned or any other Stock for that matter - please do your own research before undertaking any investment strategy mentioned - we cannot give you investment advice.

She waited for the trend to turn up, and bought 2000 Airtran Holdings (AAI) at $4.30 in January 2003 as the Stock had appeared to start a strong rally. The charts below show the trades Sidney took in this Stock. (Charts available at StockTradingReview.com)

She wrote (sold) 20 January $5.50 strike call options (one option contract covers 100 Shares) and received $440 after Brokerage.

Three weeks later, the Stock was trading at $6.00 (point 2). The options were exercised, as they were in-the-money at expiry and Sidney was forced to sell her Stock at the strike price of $5.50, netting herself a capital profit of $2400 plus the option premium of $440, a total of $2840 for three weeks or around 33% on her invested capital for the period!

She was hooked. "That was more like it," she thought.

She immediately bought 3000 more AAI and wrote 30 February call options with a strike price of $7.00. She received a total premium of $670.

The Stock price basically tracked sideways for that month, and the options expired worthless (point 3). "AHA," the light was coming on for her.

"That used to be me," she thought to herself, as she called the Broker and sold another batch of $7.00 strike price options, this time for March expiry. Another $680 was deposited into Sidney's trading account. "Every little bit helps," she thought.

The Share price rallied during March, but come expiration day, AAI again failed to close above $7.00. The options expired worthless and Sidney again kept the premium (point 4).

Sidney's total profit so far was $4190. And it had only taken her a few minutes a month to earn this income. "How long had this been going on," she thought to herself.

The buyers of all those options had to sweat out weeks of time decay only to receive a small profit in one case or a loss at the end of the time. "That used to be me!"

She decided to increase her stake, and purchased an additional 3000 AAI Shares at $6.85 at the beginning of April (for a total of 6000 shares). She then wrote 60, $8.00 strike price call options for a total premium of $1240, and then just waited for expiry.

On the day of expiry, the Stock price closed at $7.85 (point 5) - she again kept the all the premium and the buyers of those options lost all of their stake.

For May, Sidney sold 60 more call options at a strike price of $9.00 as the Stock continued to rally.

Her premium income was $1195. The Stock price moved sideways for the month and the options again expired worthless. (Charts available at StockTradingReview.com)

Sidney bought another 2000 AAI in June and wrote 80 $9.00 call options. Her premium income was $1585. She sold her call options a long way above the market because it looked like the trend was accelerating and she didn't want to leave too much profit on the table by selling them too low.

During the month, the Stock did indeed rally strongly and closed on the day of expiry at $10.47 (point 6). Her call options were exercised and she received a total of $72000 from the sale of her Stock.

For July, she immediately reinvested this amount plus a little of her own funds and again bought 8000 AAI and wrote 80 call options with a strike price of $12.00.

She wrote a higher strike price this time around because the trend appeared to be accelerating and she didn't want to miss out on too much capital growth if it continued to rally.

Her premium income was much less this month, due to the options being further out-of-the-money than previously.

She only received $650, but with the trend accelerating, she was confident that she would be exercised and stood to make a good capital gain if she was right. The price didn't quite make it, closing at $11.83 on the day of expiry (point 7)...

She continued to buy more AAI Stock and write call options during August and September. Her total profits and premium income from trading this one Stock and strategy have made back nearly three quarters of her losses from the previous 8 months. Plus, she now had a good income to live on. Her children would be able to stay with her and the future looked much brighter.

The Stock continued to climb in price to above $20 and Sidney rode it all the way, writing call options over her ever increasing portfolio. When the trend eventually changed, she sold this Stock and moved on.

Sidney can now confidently continue to build on this initial success using other Stocks that are rising in price. There is a large universe of Stocks that are both optionable and often trend strongly, which give traders huge opportunities to profit from this strategy.

There are of course some ground rules to follow, but the fact that 85% or more of out-of-the-money options expire worthless puts the balance of probability on the side of the writer rather than the purchaser in most instances.

Some things to consider are -

1) When considering writing covered calls, always buy Stocks that are trending higher - if the 30 day moving average is rising and the price bars are above it, the trend is currently up - that doesn't mean it's going to continue in that direction but you will be trading with the balance of probability.

2) Always have a stop loss order in the market in case the trend reverses and you have to exit the Stock. You will have to buy back your sold call options prior to selling the Stock as the Shares are held as security by your Broker.

3) Start off slowly and build your position over time. Continue to look for covered call writing candidates and switch Stocks if you find something better than the ones you are currently trading.

I trust this example has given you an insight into writing covered calls. It is often a lower risk strategy than straight buying Stocks or options. It can provide a great income stream for people to live on or to build wealth for the future.

To Your Trading Success,

Tony Spann and the Stock Trading Review Team

Stock Trading Review is dedicated to helping you succeed as a trader by sharing with you simple and easy to follow tips and techniques.

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