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Covered Call Picks of the Day Back-Testing Analysis...
When we set out to begin publishing monthly covered call picks of the day, we sought trades that should make money over the long-term in almost any market conditions with minimal management. To find search criteria that would result in these kinds of covered call trades, we used our back-testing tools to iterate through many search criteria and analyzed what would have happened in the past with results that met our criteria. The monthly covered call picks of the day you see on the site is the result of our unique strategy designed from this back-testing process.

Screening parameters were set up for Options, Technicals, Fundamentals, and Lists to meet our criteria. These four groupings of parameters were screened simultaneously to produce a list of monthly covered calls. Our objective was to earn 10-20% per year writing covered calls and to exit the position any time the stock price fell more than 30% from the purchase price. It was anticipated that all positions would be liquidated or assigned at expiration time in one month. Our objective was to earn income not to accumulate long-term stock holdings.

Positions were selected to be In The Money (ITM) by greater than 10% in increase safety in the event of a stock decline. Selections this far ITM would also have a high probability of being assigned at expiration.

We set the amount of return at greater than 0.8% to meet our objective of a greater than 10% return per year. We sorted the screened list of covered calls by percent return to get the highest return opportunities at the top of the results list.

A minimal bid price of $0.85 was set to require a base income to receive on each trade. Generally, the deep ITM positioning of these trades assured that base income as well.

Deep ITM positions will sometimes have very wide bid/ask spreads because they are not frequently traded. Therefore, we filtered looking for call options than had bid/ask spreads of less than one dollar and less than 50% between the bid and ask prices. Having closer bid/ask spreads should enable faster execution when limit debit orders at mid-point are used. To further help with order execution we required each issue to have an open interest greater than 10 contracts.

The selections were limited to only the highest return for each issue that met the requirements. This enabled the list of results to be more diversified rather than be dominated by many positions for the same company.

Since the use of Covered Calls is a bullish strategy, where we want the stock to go up in price, we selected companies whose stock price was higher than the 20-day moving average of stock prices. This was used as an indicator the stock was in an uptrend.

We also used the MACD indicator to assure an uptrend by filtering for the MACD signal indicator to be up for greater than 5 days and crossed into positive territory.

And lastly, we filtered for companies that had Broker recommendation less than 2.5, where the range is 1 to 5 and 1 is a ‘strong buy’ average.

Fundamentally we looked for stocks priced in the $9 to $100 range. Greater than 9 to avoid junk stocks and less than 100 to lower the total investment cost and allow the possibility of greater diversification with the purchase of more companies.

We also avoided the purchase of companies that had earnings to be announced during the one month holding period. Earnings surprises can cause increased volatility in the holding and increase the risk of success in the trade. Avoiding earnings may limit the selection list during earnings seasons. At times the minimum number of results to trade may not have been available, but the risk is too great to enter trades that have impending earnings announcements.

Selections were not limited to a particular sector or stock list.

The Back-Test Process
The testing period we used was over a three-year time span. The first half of the test period was rather flat for the general stock market, and the second half of the test period had a strong bullish uptrend. A graph of the S&P 500 Index of the test period is shown below:

The SPX change over the three years tested from 1/16/2015 to 1/20/2018

The top 3 covered calls from the screened results were “traded” each month. These selections were sorted by return and had the highest returns for the month that were available at the end of the trading day. In general, if fewer selections are used and selected from the top of the list returns will increase, but diversity will suffer and risk will increase.

Orders were entered at a net debit with the stock price at the close on Monday after expiration plus the option at its mid-point between bid and ask prices. Positions were held until expiration when they were liquidated if the call was out of the money or were assigned if ITM. Most positions were assigned because they were ITM when initially opened.

An equal dollar amount was invested in each of the 3 selections. 100% of the capital for covered calls was used each month with 1/3 in each of the selections. As the account varied in value each month the total invested varied accordingly. If only 1 or 2 selections were available, their allocated cash was uninvested that month.

Positions were stopped out and liquidated if the stock price for a selection closed down 30% from the original purchase price.

$100,000 was the base cash account used at the start of the test period.

Back-Test Results
  • Over the 3 years tested there were 87 trades, slightly less than the 108 possible trades with 3 trades per month
  • 85% of the trades were winners with a return of +3.9% on average
  • 5 trades were stopped out because the stocks were down more than 30%
  • The average loss, on losing trades was -10.7%
  • The ending cash amount was $159,031 for a 59% total return or 19% return average per year
Note: Trading results based on back-testing doesn't mean that the same results will happen in the future. It is reassuring to find support for the screening parameters used in our search for opportunities. One might expect better results in a strong bull market and worse results in a bear market.


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Picks of the Day - Sample Covered Call Trades - Trades Based on Back-testing
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