Covered Calls - Why it will work. (My opinion) Why it will not work. (Your opinion)

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1

Hello all,

I started this thread so that a discussion, if there is going to be one can be done here and will not clutter up my other thread where there is an ongoing record of trading done for the covered call strategy.

The covered call strategy is not a new strategy nor is it one that I thought up or discovered or anything of that sort.

It is a very old strategy that has been used successfully in options combination trading on the stock market in particular with “buy and hold” traders. It provided a regular streaming of income for players who have bought a particular stock and have intention of never selling it or at least holding it for a very long term. Most of these players would be commercial fund houses, family trusts and/or foundations.

In a “buy and hold” strategy, the only income source would be dividends. Covered calls then had the means for another source of revenue in addition to dividends.

In the world of forex, due to the very high volatility involved, in my opinion, one should only focus on the gain of option premium.

So how does one stand to gain or profit from a covered call strategy in the forex market.

First of all, in a covered call strategy there are two parts of the equation. Part one is the option and part two is the underlying asset.

To simplify matters, we will just use EUR/USD as the underlying asset and the EUR/USD call as the option.

Let us say the EUR/USD is at 1.38 and we purchased the EUR/USD at 1.38
We now have the underlying asset.

We now set up the covered option. Let’s say a EUR/USD Call at 1.38 strike with an expiration of 2 days at 52 pips.

This set up does not require you to predict if the EUR/USD is going up or going down. It really does not matter although one might say that going in one direction would be more beneficial than if it goes the other. This is very true but it does not really matter because one is trading a system and with the trading of a system, there are contingency actions that one must take and these will be discussed later.

In this set up, one of two things will happen as the option moves it’s merry way towards expiration in 2 days time.

The EUR/USD will either move above 1.38, or it will move below 1.38 as the option expires.

Our focus will be on the OPTION only because if you remember, we are taking a “buy and hold” position on the underlying assets so we will not unlock our EUR/USD anytime soon or maybe never at all. We are prepared to be willing to hold this for a very long time.

Let us look at what happens if the EUR/USD goes below 1.38, even if it is only at 1.3799.

The 1.38 call expires worthless and the entire 52 pips is gained. Profit 52 pips.

Let us now look at the situation where the EUR/USD is above 1.38 and it does not matter if it is 1.3801 or 1.3900

The call option will be exercised at 1.38 and will be set off against the underlying at 1.38 resulting in zero.

The premium of 52 pips is earned. Profit 52 pips.

So in essence we have a situation where if the EUR/USD goes above 1.38, we gain 52 pips and if it goes below 1.38 we earned 52 pips.

CallT

2

Call, thanks for the link…was just gonna leave well enough alone, but I respect that you opened a seperate thread for theoretical discussion and debate.

Anyway, I want to be perfectly clear about it - covered call writing IS one of MANY viable and potentially profitable strategies in the market.

No doubt about it…covered call writing works.
But so does driving a car…yet that doesn’t prevent car accidents.

I personally was a bit more impatient when i started trading options years ago (i don’t really do so any longer, though not because of losses), and I had some success with covered call writing. I wasn’t comfortable with the potential downside risk element, and with my small account was not able to make enough to really justify my time investment, so i stopped at that time.

I am curious to know what your plan is in the case of an adverse price move against you? How do you manage risk? Or more specifically, how do you manage to reduce potential risk when a larger than anticipated move against a position your holding occurs?

Like a car with a good engine and gasoline…covered call writing works, but like a car…they are better with a brake system.

I did know of a guy who wrote covered calls for stock positions…and he was about 200 years old, had traded for about 100 of those years, and said he targeted 2% per month, and had been successfully doing this for some 50+ years or whatever.

I have no doubt he was aboslutely telling the truth, but I also know he was almost obsessive over making sure he reduced or eliminated a position if it started going against him. Like…if he realized that a position was even coming close to possibly losing him 0.5%, he was out. If I remember correctly, he told me he learned after a few years, and seeing some of his associates go down in flames with covered calls…that he would pick stocks that didn’t move, like big blue chips…and watch the volatility and any potential news announcements and would even watch option pricing for any unexpected spikes in their prices.

If he saw the price of teh options start to move up AFTER he sold them…he would quickly cover if they got too expensive. He said it rarely happened, but every few years, one of his now closed with a loss positions would have moved violently against him due to some unexpected event… and it could have really hurt…or even wiped him out.

So, he literally was in the habit of taking a LOSS when option prices were so expensive that it was too good to be true. The rest of the world gets EXCITED when they can sell option contracts at very high prices for seemingly no obvious reason they should be that high…and usually, these are an options writers best months… but occassionally, that high pricing is a clue that something major is about to happen, that the majority of the world doesn’t know about (insider trading…perhaps?) and one place that sometimes shows the first red flag is the free market of options.

This was long before i was trading I spoke with this man…over 10 years ago, but I never forgot the story. He wrote covered calls, he probably had close to an 8 figure bank account…and he literally must have been almost 90 years old… and he was the only guy I met who got scared when things seemed “too good”. Of course, he also probably had close to a 10 figure bank account… so there may be something to “obsessing over risk management”

anyway, looking forward to an answer, and hope my little anecdote helps shed some light on your path through the options world.

Jay

3

Hello Jay,

Thank you for your post.

I was a bit tickled about the part of your post about the old trader and the 2%. I was tickled by the similarity. My target is also for 2% a month and very likely will get 6% a month but with 2% I am happier than a kid at christmas.

The thing about trading options and in particular in covered calls is that one needs to not be impatient as the
profits are there, just that it is not instant and one needs to wait for it to trickle in but it is there always.

If you look at my first post in this thread, you might realise that the whole premium of 52 pips is earned no
matter which way the market goes, up or down. So direction does not matter the 52 pips will be earned
either way.

There is one proviso though. In the case of the underlying going against you, the 52 pips may be earned but a loss against the underlying has to be taken but remember, the underlying is a position that one is willing
right from the start to hold for a very long while so any unrealised loss from the position is not an issue.

At this point something must be said about trading this method and that is…it is NOT meant for a small
account. We are not using a small account to try and make big profits but we are using a BIG account to
make small profits. So the issue of market going against you is not a big issue.

In the track record on the other thread, over the last weekend, there was a sustained move against the
underlying and at one point the drawdown was close to 15% so on a 100k account, we are talking a
drawdown of $15,000

In actual trading, a sustained move against a covered call position is not as sinister as one imagines and
with prudent cost averaging strategies, this can be mitigated with some level of ease.

The only way I can show this is in the actual tracking of the demo account I have on the other thread.
Come Monday, I will be doing a new set up and if we are lucky enough to have a move against the
underlying, I would be able to show you what I mean and perhaps it would then be easier to demonstrate
that a drawdown that you would see as something unsettling is not as bad after all.

Just keep watching this thread and hopefully I can show you what I mean.

CallT

4

Today’s setup.

Buy EUR/USD 1 lot at 1.3672
Sell EUR/USD 1 lot at strike 1.3670 premium 64 pips. Expires tomorrow.

In this set up. If EUR/USD goes above 1.3670 the call will be exercised and sets off against the underlying at 1.3670

The set off will be such. EUR/USD bought at 1.3672 sets off against EUR/USD sold at 1.3670 loss of 2 pips. Premium collected 64 pips. Overall gain 62 pips.

If the EUR/USD goes below 1.3670 then call expires. Profit is 64 pips.

CallT

5

We are one hour to expiration and it looks like our call will go into exercise.

That would mean we will be in profit for 62 pips.

CallT

6

It has been about 2 weeks into this strategy. We are looking at about $7700 profit out of a starting capital of $100,000 and at no time was there any threat of a margin call.

In terms of pips we have collected about 770 pips in the exercise so far.

This works for several good reasons and the two most significant ones are firstly, there is no need for trying to figure out or analyse till your head spin as to where the market is headed and where one should position for a profit. The profits are there always for the taking, no need to know where the market is headed.

The second factor is that this strategy uses a great amount of reality and blows away all the hyped up misconceptions about trading forex. Most people come into forex with $100 or less and expect to have a magic formula whereby they can tell exactly when the market will make a move and they ride on it and end up making $100,000.

It has never happened and any one saying they know someone who did it is obviously a very good story teller. The reality of the markets is that IF in the most unlikely event that you somehow managed to predict the market, it was pure sheer luck and you are not going to be able to repeat it again and again and again. That is reality.

So a $100 chasing a $100,000 profit has only one sure end. It is a different story if you set out with a $100,000 account chasing a $100 profit.

This strategy is here for you to use if you wish and to walk away from if you so choose too. It is very workable and will make you lots of money provided you have to money to work it in the first place.

If you need to know more or ask any questions, post it here so all others can have the answers too. Please do not send me any private messaging, at least not until you are very familiar and certain of the workings of this strategy.

This strategy is very old and is found in any of the books on options. The only thing is that the books don’t teach you how to use it. Many have used it wrongly and lost from it. Learn it right and it will be a source of perpetual income.

CallT

7

Just about another 4 and the half hours before the calls expire and it looks very likely to go into exercise for another winner.

We are just waiting to see if that happens and will do the next setup.

We have been doing very well and on the next setup, we would be looking to gear up on the size of the options which should then lead to more profits per day.

CallT

8

We are about 8 hours into expiration for the calls and it looks like it would expire out of the money.

This means we get to keep 100% of the premiums.

This also means we are having a sustained move against our position and riding on an unrealised loss on the underlying. This would be the situation that one should get concerned about (if you read the books) but that is just hype. This is actually a situation where an opportunity is provided for a cost averaging move which we will be employing once the options expire.

In the cost averaging move, we will be expanding our position size to reduce our entry point so that on average we have a better positioned entry level.

We will then wait to see the market’s reaction.

CallT

9

The market went strongly against the underlying in a sustained adverse move.

Calls expired so we took 100% of the premium. The market continued to move against us.

Cost averaging instituted at 1.3435 4 lots of calls.

Market continued in adverse move.

Margin is currently at 15% of assets.

We still have a very large buffer of comfort.

2nd cost averaging instituted at 1.3405 with 8 calls.

10

And if E/U continues to drop while more averaging down with increasing lot sizes are entered? Sounds like things would get painful in short order and the premiums you collect wouldn’t nearly cover the pain. Chances are you’ll probably get away with it a good few times but one bad day will destroy the account.

11

Yes, that was what I had thought too but it just never happened.

CallT

12

We be living in interesting times mon…

13

Indeed we will.

CallT

14

It is now some 15 hours to the expiration of the calls.

The market continued a sustained move against us.

At the furthest point against us the margin was at 18% of assets and drawdown was about 12%

These are numbers that are not at all uncomfortable and did not pose any concern at all. As a matter of fact, we could have taken a furthur 200 pip move easily and even to cost average against that.

This could be a paradigm shift for some who are of the opinion that holding on to a losing position is an act of insanity.

The truth of the matter is that it is TRUE…it is madness to hold on to a losing position and sheer insanity to further add to it !!!..BUT this is only true if you are NOT trading as a covered call.

If you trade a covered call, you can take a sustained adverse move of a very, very great magnitude contrary to popular belief because people never trade beyond the limits of their beliefs and thus never find out what lies on the other side of their beliefs.

CallT

15

Did those options expire before the next really big move down? What was the final damage in the end out of curiosity?

16

Yes it did expire and we increased the position. The damage can be seen on the other thread. On most strategies, two big moves against it back to back would spell absolute disaster.

CallT

17

Today is exactly one month since the start of tracking of this covered call strategy. We have made a gross profit of 1545 pips and went through two adverse moves of some 200 pips each time back to back and at no point in time was there ever a threat of even a margin call or of the account being wiped out.

We now will see how it goes through another month of trading.

CallT

18

Back on Oct. 4th you must have been running a very large unrealized loss for a while though? You had what looks like 60 lots with an avg. entry of 1.3313 and price dipped down to 1.3144 which would be an unrealized loss of the time of just over $100k. Granted it came back and you were earning premiums along the way but it looks like you were running a hefty risk there for a short while on the 4th. If you had a live $100k trading account do you think you could handle these sort of dips really?

19

Thank you for your contribution.

I do not look at the size of the loss but at the margin utilisation, I would think that there could be a miscalculation there as there was at no point any hint of even a threat of a margin call. As long as the margin stays well within safe limits there is no cause for alarm and as I remember it, the margin never came to anywhere like 50%

If the margin was never at 50% there can never be a situation of “running a hefty risk” unless we have different understanding of what risk is.

If it was a live account could I handle such a dip. Answer is yes. Anyone can handle such a situation if the margin can never come up to a call situation.

This is the advantage of this strategy but let’s hope as the days go on there will be more severe tests to really stretch out the robustness of this. I have seen this withstand a move that was 6 times the size of what we just had and it survived. Any move below that magnitude I know will never be a problem… greater than that might prove otherwise.

We can only wait and see.

CallT

20

I’m following along as best I can so far. And I have many questions!

When averaging into a position that has worked against your underlying currency pair, how do you determine how much to buy to average in?

Is there a place that details the overall strategy you are using? I have found lots of definitions of a covered call, but nothing on a practical implementation…and certainly nothing like what you are doing.

Thanks