Question

Ravi D. submitted the following,”I have found covered call writing on bio techs to be risky. How do you screen for candidates?”

Answer

First of all, I agree with Ravi’s observation, bio techs are a risky “buy-write”. This term is used when someone buys the stock and immediately writes a call against it. The end result is a covered call position, however, let’s not confuse this strategy with the investor who has owned a stock for many years and wants to generate income and add a little protection by selling a call against it. In Ravi’s case he has entered the position with the intent of generating income and possibly a small gain. In the later case, the investor bought the stock with a long term goal of capital appreciation(assuming the stock does not pay a dividend).

There are a number of “so called” covered call search engines that will find the “most attractive” candidates. I have seen many traders crash and burn using this method so I feel that it’s important to address this question. Let’s say that the search returns a stock that trades at $17.50 and the front month calls trade for $1.50. Let’s also assume the stock pays no dividend. On the surface, the trader rationalizes that if the stock stays flat or goes up he will make $1.50 on a $16.00 investment ($17.50 – $1.50). That will yield a nice 9.4% return in a month if it works out. What’s more, the stock can even drop $1.50 and he will still “break even”. These search engines focus on near term options because that is where the highest returns are found. Taking advantage of front month time premium decay is wise in most cases, but there may be a greater issue here.

A week later, there is a news item and the stock is down $5 to $12.50. Now he is down $3.50 or 22%. At this juncture the trader starts to investigate all of the news. Low and behold, there was pending litigation and the verdict was announced. These scans look for options with high implied volatilities (IV’s) and they don’t account for news. The volatility does not appear out of thin air. Someone bought that premium (it could have been both the puts and calls) and alerted the Specialist or DPM (Designated Primary Market Maker) that something was up. As the buying continued, the Specialist/DPM backed off until the premiums were sufficiently high. This resulted in high implied volatilities and there wasn’t even a move in the stock. It could have been the Specialist himself that was aware of the release date and the weight of the decision. To buffer his risk and adjust his reward for the news he raises the IV’s without and option even trading. It’s his business to know. The point is that high premium exists for a reason. It is not some buried treasure that has escaped everyone but you.

In other instances, the stock may just be very volatile and the premiums are normally high. If I have done extensive research, I like the stock and I’m willing to assume the risk – the trade may make sense. This will often be the case when a good stock has been “taken behind the shed” and it looks like a good value. I evaluate the stock’s support and resistance levels and I subtract the proceeds of the call I sold to calculate my net cost. The key to my approach is I look for the stock first. I want to own the stock and I’m willing to sacrifice some upside in return for a little protection. In the event that I find a nice stock that has not been wild, I look at historical IV’s to make sure there has not been a recent increase. If the IV’s have increased for no apparent reason – I won’t do the trade. That is common when an option spans an earnings release date and the front month is expensive relative to the next month out.

If there is any kind of scheduled (earnings release) or anticipated news event, I will avoid this strategy like the plague. I’m paid to predict price movement, not to gamble on the unknown. I don’t have the research to compete with the “big boys”. There is no logic in capping my upside on a wild stock and assuming virtually all of the downside risk. This strategy needs to be handled with great care when high IV’s are concerned. One bad trade can wipe you out.

Focus on the stock, not the premiums for this strategy.

Now you can win by answering my question. Instead of doing a buy-write on a stock stock that does not pay a dividend, what would be an equivalent, more efficient approach and why? The best answer gets a free one month subscription to the OneOption service of their choice.

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