The Role of Psychology in Covered Call Writing

When I was writing covered calls month after month, nothing gave me more pleasure than to see the stock soar, making it extremely likely that I'd be assigned an exercise notice when expiration day arrived.  It was always a pleasure to part with my shares because I earned the maximum possible profit from the trade.

When trading a position with limited profit potential, earning those profits is something to celebrate.

But not everyone thinks that way.  I frequently read the laments of traders who were not satisfied with those gains.  Trying to earn more than the maximum for the trade, once the call moved into the money, they bought back that call, hoping to see a continued rise in the stock price.  And sometimes the wish came true.

But just as too many investors buy tops and sell bottoms, too often the stock reversed direction, and the sure profit turned into a loss.

Why would anyone do that?  It's understandable.  For some people making a profit is not good enough.  They want to sell at THE TOP and take the most possible cash out of each trade.

If that's you, I can recommend a solution.  It's almost guaranteed to keep you from risking your hard-earned profits in an attempt to eke out just a bit more.


Solution

Instead of writing the covered call, sell the equivalent put (secured by enough cash to buy stock if assigned an exercise notice).  To be certain there is no misunderstanding – this is the put with the same strike price and expiration date as the call being written in the covered call play. 

As previously discussed, the covered call and naked put are equivalent positions and when expiration arrives, the profit or loss from each trade is roughly the same .  Any difference may come from commissions or an option being mis-priced by a couple of pennies.

This time, when the stock rallies, the investor's position is short the put – and that put steadily decreases in price.  As it moves towards zero, the investor is pleased and there's no reason to buy back that put to sell another.  Somehow the picture looks different when selling the put than when owning the covered call.

Yet the trades are equivalent.  If you are someone who has trouble keeping your mitts off a winning covered call trade, consider writing the puts instead.  Human nature makes it a pleasant experience to see the stock rise in value when you are short the put even if you would be unsatisfied when writing the covered call.  

Any edge is good when trading and if this psychological edge would help you, then do it.

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7 Responses to The Role of Psychology in Covered Call Writing

  1. Steve 02/23/2010 at 5:58 AM #

    Mark,
    I’ve got a related question.
    I know, from this blog and your excellent book, that you recommend not waiting to extract the last few pennies from a winning short options position.
    Many of us have simple rules to close winning positions, such as when the option premium has lost 75% of its value or when the option premium drops to $0.10.
    I’m trying to formulate a more formal system for this.
    A CSP example:
    I originally sold a far out of the money SPX put option for $1.10 with 49 days to expiration. This gives a potential profit of $2.24/day.
    Currently the option is priced at $0.25 with 27 days to expiration. This gives a remaining potential profit of $0.93/day.
    The daily profit available has fallen by 58% – is there some figure or formula to indicate when it’s time to close the trade?
    Steve

  2. jeff partlow 02/23/2010 at 6:39 AM #

    Hi Mark,
    Thanks for presenting this article on a topic related to covered calls.
    Steve’s question above as well as the oft repeated discussions on the JustCoveredCalls Yahoo Group regarding the question of when or whether to either (1) close out; or to (2) roll out; the short puts (in the case of cash-secured puts) or the short calls (in the case of covered calls) leads me to conjecture that there is an insignificant difference concerning the “What to do?” question when one compares the comparable decision facing either the CC or the CSP writers.
    In a related (albeit different) line of inquiry, it seems to me that individual investors who are put writers might be slightly more conservatively oriented in that they tend to sell out-of-the-money strikes whereas covered calls investors are more likely to be somewhat more agressive in that they seem to have a greater tendency to sell out-of-the-money calls. Do you have any thoughts on this question? Are you aware of any academic research in this regard?
    Best Regards,
    Jeff

  3. Mark Wolfinger 02/23/2010 at 8:15 AM #

    Steve, more detailed reply coming soon.
    CSP = cash secured put
    Steve, there is no formula that is ‘correct’ – but there surely is one that will work for your style of trading, individual risk/reward profile (comfort zone), and the way you think about taking profits.

  4. Mark Wolfinger 02/23/2010 at 8:21 AM #

    Jeff,
    Agree the “what to do” decisions are similar regardless of whether the trader is using covered calls or selling naked puts (cash secured or otherwise).
    The decisions merely look very different because the trader does not yet recognize that the positions are equivalent – and thus, the ‘decisions’ are similar.
    Not aware of academic research. This too, is worthy of a blog post. Give me a few days to respond.

  5. Larry 02/23/2010 at 10:51 AM #

    Mark, couldn’t agree more on the psychological aspects of using options. I’ve only been trading covered calls for several months now so I still consider myself a rookie. I started out trading some short term, medium term, and long term (LEAPS) options and have been interested to see how using options helps keep my emotions in check and avoids the “I have to do something NOW” mindset. (Either strong upside or downside moves)I’ve also practiced how to manage my risks when a stock moves close to my breakeven basis. It’s comforting to see that there are “options” (no pun intended); that can reduce downside moves that don’t require the sale of the stock.
    Enjoyed your webinar on Trade King. Even though I didn’t catch it live I viewed it later when they posted it on their site.
    Regards
    Larry

  6. Michael 02/23/2010 at 6:07 PM #

    Hi Mark,
    This is an interesting insight into trading psychology. I trade a roughly equal number of cc’s and cash-secured puts. I’ve tried to train my mind to “be glad” when in a cc position and the underlying rises. Most times, but not all, I’m successful in being glad. I simply like the edge wasting assets (sold options) give and tell myself the maximum profit on my play may be realized if I am called out.
    Michael
    http://www.safe-options-trading-income.com

  7. Mark Wolfinger 02/23/2010 at 7:29 PM #

    It’s really something when we have to train our minds to believe something we KNOW IS TRUE.
    Thanks for the comment.