The fundamental problems with trading in general are too vast for the purposes of this article. However to summarize, they are your own personal mentality and position sizing. I recommend reading Trade your Way to Financial Freedom by Dr. Van Tharp.

The two major problems with covered calls are that it limits your upside potential and to a lesser extent the extra trading costs since you buy the stock and sell the call. This is what you can do to mitigate these effects…

Transaction Costs:

Compared to a standard stock strategy, the transaction costs are roughly double or more than double since the option trading costs are generally higher than the stock.

To counter this, you need to trade with enough money per position. I can not say this any more simply. However, let’s examine just how much OptionsXpress’s transaction costs are for an active trader (which if you do not qualify for, you are not following good position sizing). In this case, the minimum charge for the stock is $9.95 and the option $12.95. Thus the minimum amount for a full position is $22.90 if you are not called out at the end, $32.85 if your ARE called out, and all the way to $45.80 if you roll out early to lock in your profit.

A good standard amount for covered call traders is 3.5%, some will be more and others less. So let’s look at how much you would make trading various amounts earning 3.5%.

$2,000 - $70

$3,000 - $105

$4,000 - $140

$4,500 - $158

$5,000 - $175

$5,500 - $193

Also taking taxes into account, (lets say 20%) how much are you comfortable trading with now? If your initial positions were $2000 do you still think this is adequate? What about the positions where you only get 2.5% ? This decision is entirely yours, but my opinion is that it is silly to use any position sizes less that $4,500 per position, preferably more.

(An entire other topic is how many different positions to get into at once, which I will not get into here, but to summarize my view, at least five)

Limiting your Upside

One of the golden rules people like to quote for trading is to cut your losses short and let your profits run. However, in covered calls you can not “let your profits run” since it limits your upside. To understand how to deal with this, one must understand the differences between probability and expectancy.

Probability – the percentage of time that each position is “right” or you make money. Most people assume that a trading system where you are wrong 80% of the time is horrible and you are sure to loose money. But what if when you were right that 20% of the time, you made 10 times as much per position when you were wrong? Would this be a good system? Yes it would.

But in a covered call strategy, being “wrong” 80% of the time would not be good, since when you “win”, it is impossible to make much more than when you loose.

Expectancy – How much you make per amount risked, given in a number times “R” written in the format of “0.5R”. This means that overall each position you risk “R” and overall you make “0.5 * R”. Here is an example.

Suppose you buy ABC stock for $28.20 and sell .abc call for $1.20 (the strike does not matter here). Looking at the chart you decide to set you stop at $26.20 and you will buy back the call at market (using a “one triggers other” market order). But you do not know what price you will buy back the call, so you guess you will buy back the call for 20% of what you sold it (I base this on experience). In this case you will buy back the call at $1.20*0.20 = $0.24.

So the amount you risk is ($28.20 – 26.20) + (0.24 – 1.20) = $1.04. Thus 1R=$1.04.

Lets say at the end of the month you were called out and you made a good 3.5% which correlates to $0.945 ( = ($28.20 – 1.20) * .04). Note the 3.5% is taken from the NET-DEBIT and not the stock price.

So for this position your “R-multiple” is the amount you made divided by the risk or

0.91R = ( $0.945 / 1.04 ). Note that if you lost money, this would be negative.

This is your R-multiple for this single position. To determine you expectancy, you must take the average of ALL you “R-multiples”. An expectancy greater than 0.0R means you make money.

The next point is how high can each “R-multiple” be for each position? Or how much can each position make compared to how much I risk in each position? The answer varies, but on average most positions I enter have an R-multiple of 0.6R, few getting above 1.0R (the ones that do have more to do with where the support is on the chart compared to my stock purchase price). Compared to other trading strategies, this is not good. A trend following system can have high max R-multiples of 10R or even 20R, which is impossible with covered calls because it “limits your upside”. But trend following trading systems are “right” maybe slightly better than average, lets say 55%. Thus in order for those to be profitable, the 55% of the time has to be greater R-multiples than that of the R-multiples when they loose. Thus on average, the mean of all their “R-multiples” will be greater than one and they make money.

So my overall point on how to get around the fact that covered calls limit your upside is this…

Since covered calls have low max R-multiples, you have to have a high probability trading system.

You WILL have positions stopped out. This is inevitable. However, you have to keep these as infrequent as possible or you will have too many negative R-multiples and when you average them all together, your overall system expectancy will be negative. Because of this, it is my preference to only do an ITM strategy since these are significantly more likely for me to NOT be stopped out. Furthermore, I like only medium to large stocks reasonably priced that actually earn something.

Some may be thinking if I keep my R’s very small (by keeping very tight STOPS) then my R-multiples will be large. This is entirely true, but you will find that you will get stopped out a LOT and you trading costs (that other bad thing about CC’s) will overpower any profits you make. You have to give your position some room to move.

Another option I suppose may work is to shift to high yielding CC opportunities, such as the potentially most profitable OTM positions that would be on coveredcalls.com. These are very volatile and STOPs would be frequent, but occasionally you will get that “winner” making a lot and hopefully enough to overpower you losses to get a positive expectancy. This is a much riskier strategy but potentially more rewarding. You have to have a lot of control and a good position sizing strategy for you not to get destroyed. This is past my acceptable level of risk, but it may not be past yours.

For those of you wondering what my probability and expectancy are, my probability is 82% or I get stopped out 18% of the time. My expectancy is 0.16R, which I admit is lower than is desirable. However in my defense, in my early trading days I did not understand what I do now about controlling risk. It scares me sometimes looking back at my earlier positions that if I would have been stopped out I would have lost up to 5% in my account! These types of positions resulted in very small R-multiples for profitable positions, and thus lowered my overall expectancy.

Another point that must be said is that I have only been trading CC’s in an upward market. I believe that CC’s will also work well in a downward market, but they must be much more ITM, perhaps up to 10%. In this scenario, the total profit would most certainly be less than in an upward or sideways market.

I have been trading covered calls for a while now. It has been an interesting ride with some expensive "learning experiences". Overall I am profitable. Visit my website for more information and a great tool for any covered call trader http://www.coveredcallcalculator.net