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The Biggest Mistake Covered Call Traders Make

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I'm asked this same question time and time again! If the majority of my covered call trades are profitable, why am I unable to outperform the major market index?

The answer is quite simple: risk management. I've spent over 16 years speaking with covered call traders. I'm fascinated at how willing they are to voice their results. I recently had an experienced trader state: "Over 65% of my covered call trades are profitable." My response was "Wonderful!" And I then proceeded to ask him, "How much did you earn last year trading covered calls?" Let's just say he was less anxious and less forthcoming.

Without auditing his trading journal, I could foretell the problem. He overlooked risk management. A covered call trader is faced with two types of risks: the risk of experiencing a large loss and the risk of running across a losing streak. While neither one is completely avoidable, following a few simple steps can help minimize losses and reduce equity drawdowns.

Large losses should be managed with stop-loss orders. Yes, a stop-loss order on the entire covered call position! Many covered call traders fall in love with their stocks and plan to hold their positions into perpetuity. They fail to understand the true risk-to-reward relationship of the trade. If an upside profit is limited, then a downside loss should be limited too. For instance, let’s take a look at the following trade:

Is it logical to risk $28.75 in order to make $3.75? That's a (28.75:3.75) risk-to-reward ratio. I'm not sure about you, but that's too much risk for my blood. If, however, I enter a stop-loss order at $25.00, then I can reduce the risk to $3.75 and improve my ratio to (1:1). This is a very simple remedy; nonetheless, it yields a more acceptable and more manageable number.

Losing streaks are another issue - one trade after another triggers for a small loss. Streaks tend to occur during major market corrections and can ravage a covered call portfolio. One way to neutralize this risk is through portfolio diversification. A properly diversified portfolio of stocks from different industry groups will reduce risk; however, you cannot stop there. One should also trade a few uncorrelated trading strategies. For instance, covered calls are a neutral to bullish trading strategy, so one should also trade a second strategy that is perhaps neutral to bearish, e.g., bear-call spreads or naked calls.

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Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

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