Covered Call Solutions For All Market Conditions

Covered Call Solutions For All Market Conditions

By:


Covered call techniques are well favored by options traders because of their ability to generate regular cash flow in the long term. In markets that rise or trade sideways, the call option premium delivers the income, while in falling markets, this exact same premium offsets the losses. Investors have used covered calls for more than 30 years. They're so well received that in 2002 the Chicago Board Options Exchange launched the earliest major benchmark index for covered call strategies - the CBOE S&P 500 BuyWrite Index (code BXM).

To make the best possible yields from covered calls, it's generally recommended to apply them to stocks and shares with a significantly greater historical volatility. Although this appears rather counterintuitive, studies have shown and even Warren Buffett has commented that there is "no correlation between beta and risk". The key reason why these volatile stocks can be so appealing is the fact that they're able to return 40%+ each year - not necessarily because the stock price is preparing to rise significantly but for the reason that inflated option prices reflect the outlook for underlying stock volatility.

But covered call strategies also carry a measure of risk therefore we need to employ the right course of action to different market conditions. The worst case scenario occurs when you acquire a stock, write out-of-the-money covered calls at exercise prices higher than the buying price and next thing the same stock price has a big plunge. Under these scenarios, the option premium you have just received will most likely not offset the capital loss on the shares themselves.

So what can you do?

Your original sold OTM calls will undoubtedly be considerably devalued at this point, so you could repurchase them 'for a song' and immediately sell additional call options at a lower strike price. This would pull in further premium to offset the capital loss to the shares. However, if you're depending on covered call strategies for a regular income you won't be making anything on those shares this month and if the price continues to fall, you may even have to accept a loss.

So although writing OTM covered calls is ideal for a sideways or bullish outlook for a given share, it may not be the best notion if they are near their price peaks. You might pay for protective OTM puts at exercise prices lower than the share purchase price but this would lower your overall income. Protective puts are a better strategy if you're more "investor" than "trader" oriented and propose to retain the shares for a while.

Still, in a bullish trend, OTM covered calls give the most beneficial outcome - you are given option premium together with a capital gain on the shares themselves. But for this plan to work, you should employ the best research tools to raise the chances for success.

What About a Bear Market?

When the general market condition has turned bearish, you can make a consistent income making use of the appropriate covered call strategies. In this case, the most suitable alternative is to sell IN-the-money call options over your stocks or commodity futures. The intrinsic value in your sold call options will work in your favour should the underlying price fall. If these options transform into OUT-of-the-money you'll be able to buy them back at a far cheaper price than you sold them for, thus earning a profit. In the meantime the extra premium you have obtained from the ITM options will furnish a far greater buffer against decreasing share prices than out-of-the-money premiums.

After the stock price has fallen substantially (but not under your ITM call option exercise price) you 'buy to close' the sold options and immediately sell MORE in-the-money calls at a still lower exercise price. The earnings you are making under these conditions are from the 'time value' of the options which, if prices have become volatile may also include some decent implied volatility to enhance your returns.

And Sideways Markets

If you've found a share price which is caught in a range or sideways channel and unlikely to move much either way in the short term, it is quite probable that option prices will be cheaper on account of low implied volatility. This will reduce your potential income, but that's what you exchange for lower perceived risk. For stocks like these you should consider selling AT-the-money call options on the stock. You can expect to receive more premium than for OTM calls and because the stock price isn't really moving much, you just 'rinse and repeat' each month until things change.

You can look for for these kind of stocks using a good stock and options screener, which most reputable brokers include as part of your account.

Earning consistent returns from covered call strategies is simply a matter of deciding what risks and returns you're comfortable with and then applying the most suitable method.

About the Author:
Owen has traded options for many years and writes for Options Trading Mastery, a popular site about profitable Option Trading Strategies. Discover a wealth of information about options, including the best Covered Calls strategies.



Article Originally Published On: http://www.articlesnatch.com


Tags: , ,

|

Loading...
Related....
Videos...

Recent Investing Articles

Comments

Still can't find what you are looking for? Search for it!

Loading

Site Navigation:

Copyright 2005-2011 ArticleSnatch, LLC - All Rights Reserved.
Privacy Policy | Terms of Service.