What is the Best Type of Covered Call Trade?
This is kind of a trick question because we believe the best type of Covered Call trade is not a Covered Call at all. We prefer to trade Diagonal Option positions instead of a traditional Covered Call.
Let’s start with what is a Diagonal Call trade, just in case you do not know.
A Diagonal Option trade consists of buying a long term deep in the money (ITM) lower strike Call Option and selling a shorter term at the money or slightly out of the money Call for income generation.
In choosing your deep in them money covered call look for one at least over Delta .90 so it moves close to the same as the underlying security. You also need it to be at least 90 days out before expiration or more. Sometimes we go as far as 180 days out.
Your short option is up to you. We typically start out selling an at them money Call expiring 7 to 10 days out when we start the trade to give us good downside protection. Yes, that means we might have to pay to repurchase and roll it if it finishes in the money but if it is not too far in the money
We keep rolling our short option out 7 to 14 days each time it gets close to or expires. We do this as long as the underlying security supports staying in the trade.
Why do we prefer a Diagonal to a regular Covered Call? Simple, return on investment.
If a stock is trading at $60.00 then to purchase 100 shares will cost you $6000.00. If you can sell an at the money $60.00 Call against it for $1.50 or $150.00 and assuming you don’t roll then your return on expiration if the position is ITM would be 2.5% ($150/$6000).
If you use a Diagonal Option trade and purchase the $35.00 Call Option for $26.00 or $2600.00 and sell the same at the money $60.00 Call for $1.50 or $150.00 then your return would be 5.8% ($150/$2600).
As you can see you can get twice the return using a Diagonal instead of a regular Covered Call.
When is a standard Covered Call trade preferred?
We can only think of one instance. If you are collecting dividends as part of a Covered Call strategy then you would have to purchase actual shares of the security to collect dividends. If you use a Diagonal Call strategy then you will not collect any dividends. But, the return is so much better who cares about dividends.
So, next time you are looking for a good Covered Call trade … think Diagonal instead.
Originally Published on Trade4Profits.com by Jim Dawson