5 Tips for Covered Call Traders - Tip #2

Shoot for the Clouds, Not the Stars

I'm not talking about your hopes and dreams. I'm talking about returns. It is tempting to write covered calls on highly volatile stocks (though what isn't volatile these days?) because of the extremely high call premiums that can be reaped.

This is a double-edged sword, because extremely high implied volatility readings tend to be associated with extremely volatile stocks! Shocking, huh? This is especially true with small caps, biotechs, and these days, financials.

Let's take Citigroup (C) as an example. The stock closed at $14.18 on October 21, while the November $15 call option closed at $1.13. The implied volatility on that option is currently 101%, which is pretty fat. By buying the stock and selling that particular option, the cost basis per share would be $13.05. And in the absolute best case, you could earn a return of 14% in about a month.

But there's a problem - Citigroup is one heck of a wacky stock, and it could be at $10 in a month (-22% return) just as easily as it could be at $20. As a personal rule, I tend to stay away from stocks where the options carry volatilities that are out of whack relative to the options of similar companies.

Occasionally, there are traders out there with some piece of information you don't have, and they will aggressively buy options, which has the effect of increasing implied volatility readings. Remember, implied volatility tends to be high for a reason, so don't go crazy with your covered call trades!

The Rest of the "5 Tips for Covered Call Traders" Series

Tip #1 - Pick a Stock You Believe Will Go Up!
Tip #3 - Stick With Short Durations
Tip #4 - Watch Those Commissions!

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