Building Your Farm
After you decide you want to adopt the covered calls strategy the next step is to "build the farm" Steps to consider are:
1. Learning about the strategy. Your education about covered calls. It is critical that you become knowledgeable about how all this works. This is a hands on approach. If you really don't want to spend the time learning and applying the strategy you may be better off staying with your current investment approach. There are a lot of ways to make returns in the stock market and you may have already achieved your benchmark targets.
To help you in your education you can refer to the Seed Store. I have listed a number of ideas you can consider to
learn about the strategy. You can also do a web search of Covered Calls and will find many references including dedicated websites. There is more then enough information to educate yourself if you have the desire.
2. Open a brokerage account that will allow you to write covered calls (you can modify your current account if you already have a brokerage account). You will want to make sure that your brokerage commissions are low to maximize profits. I use Charles Schwab as my primary broker and they have a number of good tools to help me manage my farm. I also understand there are other brokers who can also offer you similar products. Regardless of who you decide just make sure they offer low cost commissions and provide a good variety of tools to help you do buy/writes and manage your covered calls.
3. Develop your Covered Calls Farm Big Rules. It's important to set back and decide on the big rules you plan to run your farm. This will help you set the stage for what you expect, help keep emotions lower, benchmarks, etc.. Be sure to establish the maximum you will invest in any one position. I started with 5% of my assets but have recently dropped it to 2% maximum as my account has grown.
You can easily get caught up in buying too much of a high call premium stock which may make you a lot of money. However, anything can happen even to the best of stocks so why risk too much capital in a single stock. Just like a farm, it's not prudent to bet on just one crop vs. being more diversified.
An example of some of my rules are:
4. Decide on Which Crops You Will Grow
You need to decide what kind of calls you will write (or plant).
You need to decide on your own strategy. Remember, you can always do a variety of each crop and not have your economic future tied to one crop. Go to the Crops
I have attached a chart that shows a possible targets for call writing based on my target. This is expressed in actual percentage by months.
5. Maximum Initial Investments and What Kind of Brokerage Accounts
Based on my experience it seems difficult to make a solid return with covered calls with a small account (say less then $20,000). The reason is that you have little room for error in picking solid stocks. If just one or two drop it will hurt your annual return. I believe an account with at least $50,000 or more has a better chance of being successful but of course it will depend on your stock selection and management of the account along with the actual market performance. Nothing wrong in starting with less then $20,000 but just be careful not to invest too much in one position.
I have both a regular brokerage account and an IRA brokerage account fully invested in covered calls. The IRA is the best because you don't have any tax consequences until you take an actual distribution from the account.
A regular brokerage account does generate a taxable event with each transaction and you need to make sure
you manage your taxes closely each year. Of course, nothing wrong in paying taxes if you are making solid profits.
You can write calls in both kinds of accounts. You will need to set them up for call writing which is an easy process with your broker. Most can be set up online or you may have to call your broker to set it all up.
6. Select a Few Stocks to Start Your Farm
I have found over 90% of all the stocks I use for covered calls in Investors Business Daily (IBD) and particularly from the weekly IBD 50 list. To find stocks for call writing I do the following using the IBD.
a. The IBD 50 is published in the Monday edition. However, it can be purchased and/or home/electronic delivery
on Saturday morning. I spend a couple hours maximum doing a quick review of the top 50. I review the information provided including the chart pattern. Based on my experience if I like the stock based on what I have seen I then determine if it has options and the actual premium % based on my targets. To determine the actual call premiums
I use the Fidelity systems. If you review call data when the market is closed it may not be accurate. Best time is when the market is open.
b. For all stocks selected that meet my call premium actual targets I put them on a list for possible purchase
on Monday morning (assuming I have buying power in my account). In some cases, I already own the stock and
decide to add more to my current positions.
So, if you have completed the first 6 steps you are now ready to do your first buy/write in step 7.
You will need to select a couple stocks that meet your criteria and actual/per annum premium targets.
7. Do Your First Buy/Writes
You can create a new buy/write a couple ways. First, you can buy the stock and then secondly write a
covered call. This would be two separate transactions with commissions separate for each transaction.
You can also do what Schwab calls a Multi-Leg transaction It is a system that combines the stock buy
and call sell together. It results in a net price but still requires the purchase of stock and selling the call
separately which is done by the Schwab systems automatically. The system works to make sure the net price is the price shown when you made the order. Typically, the commission are lower on a multi-leg transactions.
Most of the time the multi-leg transaction executes fairly quickly. However, sometimes it takes a long time and I have even had a few that did not execute all day. The reason is that the net price must be realized or the order request is not executed. After a few minutes I sometimes will go in the system and do a cancel and replace of the same trade. When it appears that multi-leg is not going to execute timely I have canceled the transaction and gone ahead and bought the stock separate and then sold the call. It costs me more but I am able to do a buy/write that I really want to execute. Each broker may do this a little different.