IVolatility.com - data and services usage
Covered Call Writing using Strategist Scanner

We will consider the use of our Strategist Scanner service for a Covered Call Writing strategy in this newsletter. As usual, we'll double-check the output of this service with our Stock Sentiment service, and filter out the stocks with unsuitable market expectations.

Strategy basics and sample scan

Writing of a Covered Call is considered to be a moderately bullish strategy. It consists of writing Call contracts against long stock position, in one to one ratio (1 Call contract against 100 shares of the underlying; the ratio can be different from 1, giving "partially covered" position). This strategy has a limited upside potential, while downside risk is limited only by the underlying price going to zero (practically speaking, unlimited downside). As a compensation, this type of trade normally has a high probability of profit, that's why it is rather popular, notwithstanding the drawbacks above (limited profit, unlimited risk). Maximum profit is achieved if the stock is called, that is, if the underlying forward price is greater than or equal to the option strike.

Below we show rather realistic examples of filters to use, though they are quite restrictive initially:

Fig.1 Sample profile for Covered Call Write

We include all US stocks, having a stock price greater than $10 per share to exclude "penny stocks" from the very beginning. We choose margin type of account, to get the most leverage (it is assumed that you have to deposit (additionally) 50 % of underlying to enter the trade, but can apply the proceeds of the option sale).

We'll use out of the money Calls (moneyness of -5% or less), with less than two months to expiry. We set minimum option price to $0.20 ($20 per contract), to avoid too deep out of the money options.

Now let's look at the general requirements to the position we impose:

  • Minimum return if stock called: 20 % (so, not less that 120% annualized, if no compounding is assumed)
  • Minimum return if option expires worthless: 5 % (means 5 % return if forward price exactly equals to the current underlying price)
  • Minimum downside protection: 10 % (so, you break even if underlying declines by 10 % or less)

Finally, we exclude the future dividends from P&L calculations; including them can give somewhat too optimistic profit expectations, and you never can be sure that Call is not exercised against you before the dividend record date.

Scan results and further analysis

The Fig. 2 below shows the results of scan above, as of Monday, September 27, 2004 close:

Fig.2 Results of scan as in Fig.1, September 27, 2004 close.

As you see, there are only 4 NASDAQ names in the output; which can be expected as our requirements of minimum return and downside protection are rather stringent. And this is not all yet: we still need to check market sentiment for each of these potentially promising trades. Moderately bullish to bullish sentiment is the only one we are going to accept, entering the Covered Call Write strategy.

Let's have a look at what Stock Sentiment service tells about these names:

Symbol Name Buy Sell Hold Sentiment
AGIX ATHEROGENICS 2 4 3 moderately bearish
VXGNVAXGEN INC233moderately bearish

Tab.1. Sentiment for the names from Fig. 2.

Well, only NKTR:NASDAQ passes the sentiment test; one name from all US looks a bit too poor, so we evidently need to relax our requirements (minimum returns and / or downside protection in the first place). We can choose to sacrifice the downside protection; relaxing the requirement to 7.5 % yields another 5 NASDAQ names, but only one of them has the suitable moderately bullish sentiment - APPX:NASDAQ, AMERICAN PHARMACEUTICAL PARTNERS, INC (Buy 3, Sell 2, Hold 4). The Call option chosen for APPX is November strike 30.
Further relaxing of minimum downside protection to 5 % yields far more names - 25, and 8 of those pass the sentiment test.
We summarize the data for all the 10 names found in the table below:

SymbolNameOption strikeDownside protection, %Sentiment
CRDNCERADYNE INC CALIF455.5moderately bullish
ELN:NYSEELAN CORP, PLC256.9strong bullish
LRCXLAM RESEARCH CORP22.55.0moderately bullish
NABINABI INC12.56.7moderately bullish
RECNRSCS CONNECTION405.3moderately bullish
UTSIUTSTARCOM, INC17.55.0moderately bullish

Tab.2 Covered Call Write opportunities found for min downside protection = 5 %; all the options expire in November 2004

Mind, that for names like ELN:NYSE, RIMM:NASDAQ (and, maybe JUPM:NASDAQ and NKTR:NASDAQ) it is worth considering more aggressive bullish strategy than Covered Call Write. Stock Sentiment service gives a very bullish rank so maybe a straight Naked Long Call strategy is more promising (you'll need to check for cheap Calls for these names then, for example, by using Intraday Option Scanner service).

Strategist Worksheets section

Finally, let's have a look at expected P&L profile for our "best candidate", NKTR November 04 15 Call. This is done by just clicking on the stock symbol field in the output record of the Strategist Scanner. After you click, you will go to the Strategist Worksheets section - quite an intuitive calculator for Naked Put Write, Covered Call Write and Protective Put Purchase strategies. It is worth mentioning here, that Strategist Scanner itself fits for Naked Put Scans as well.

We will describe this section in details in our coming newsletters, for now just let's have a look at the P&L profile chart shown there for NKTR position:

Fig.3 P&L profile for Covered Call Write (margin and cash accounts) and straight stock purchase

Clearly seen, that the usage of leverage (margin account) promises the largest returns (about 38 % till expiry), but bears the larger risk should the underlying decline below $12.