5 Times to Avoid Selling Covered Calls

Selling covered calls is a great strategy that I use on my longer term investments to generate a monthly income. All and all it really is a great strategy, but there are 5 critical times that selling calls on your stock just does not make sense.

These are..

1. When a Stock is in a Downtrend

But you have to realize that you can lose money too. So it is best to avoid opening up a covered call position on a stock that is down trending, breaking support, or bouncing off of resistance. If you are interested in a certain stock that is going down you can always wait until it starts to level out before entering it, after all V bottoms are very rare. Stocks normally switch from going down to going up very slowly.

2. Bad Fundamentals

Covered calls work very well as a long term strategy. Anytime I enter a stock to sell calls off of, I know that I can potentially be in the trade for a long time. So I want to make sure that the underlying company is solid and worth investing my money in.

Some financial ratios such as the PE ratio give you a good idea whether a stock is undervalued or overvalued. It is also a good idea to use your own judgment when dealing with a company.

Companies like Disney or McDonalds are not going to go out of business anytime soon, and sometimes that is all you need to be profitable selling calls.

3. Low Option Prices

Not all stocks are created equal. Some stocks will pay you $6 premium for a call option 15 points out of the money, others you will be lucky to receive $.50 for a call option 2 points out of the money. When selecting a stock to sell covered calls on the price of the options is obviously very important.

It can be helpful to look at the current options listed and compare those to the price of the stock as well as how far away they are until expiration in order to determine whether or not you will be able to sell options and get a decent return from them in the future.

4. Up Trending

Selling covered calls severely limit your upside potential. Your max gain is caped at the price you sold your call for. I don’t have to look too far back in my own trading to be reminded of this. In fact last August I owned stock MTL which was trading at $4.5. I sold the $5 call for July on the stock and made $.80.

I figured a 16% return in 4 months would be ok for me, if it went above $5 I would have no problem getting called out. Little did I know that the stock was on the verge of a major upward move. Less than 2 months later MTL is trading at $8.68, almost double what it was trading at when I sold the call.

My point is, sometimes it is a wiser decision to not sell calls on your stock at all, I would rather take a 100% gain on a stock then to take a 16% gain on an option any day of the week. And although you cannot avoid missing some profits when you sell calls, (it is just part of the risk) you can lessen the amount this will happen by not selling covered calls on up trending stocks.

Sometimes it is just more profitable to hold onto a stock and profit from appreciation then it is to sell calls on it.

5. When You Can't Accept Being Called Out

When you are selling covered calls on a long term investment you will probably exit the trade in 1 of two ways, the stock will either go to $0 or you will get called out.

If you cannot handle the slight possibility that you may get called out of a position, don’t sell covered calls. If you keep selling calls on a stock it is not only a possibility that you will get called out, it is very likely. You have to accept that the amount you make by selling calls over and over again can outweigh any possible risk of missing a profit you might encounter. If you cannot realize that, this strategy is not for you.

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