Covered Call Strategies

Covered call strategies are popular with options sellers due to their capacity to generate regular income over time. In markets that rise or trade sideways, the call option premium supplies the income, and in falling markets, this same premium offsets the losses. Investors have used covered calls for more than 30 years. They're so popular that in 2002 the Chicago Board Options Exchange released the first major benchmark index for covered call strategies - the CBOE S&P 500 BuyWrite Index (code BXM).

To make the best returns from covered calls, it's generally necessary to apply them to stocks and shares with a much higher historical volatility. Although this appears somewhat counter-intuitive, research has revealed 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 that they're able to return 40%+ per annum - not necessarily because the stock price is going to rise dramatically but because the inflated option prices reflect the expectations for underlying stock volatility.

But covered call strategies also carry a measure of risk so we need to apply the right approach to different market conditions. The worst case scenario is when you purchase a stock, then write out-of-the-money (OTM) covered calls above the purchase price but the same stock price takes a big dive soon after. In cases like this, the option premium you have just received will probably not cover the capital loss on the shares themselves.

So what can you do?

Your original sold OTM calls will be significantly devalued by now, so you could buy them back 'for a song' so to speak and then sell more calls at a lower strike price. This would bring in further premium to offset the capital loss on the shares. But if you're relying 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 decline, you may even have to take a loss.

So while writing OTM covered calls is great for a sideways or bullish outlook for a given share, it may not be the best idea when they are near their price peaks. You could purchase protective OTM puts at strike prices below the share purchase price but this would lower your overall income. Protective puts are a better strategy if you're more "investor" than "trader" minded and plan to hold the shares for some time.

Neverthelss, in a bullish trend, OTM covered calls give the best outcome - you receive option premium plus a capital gain on the shares themselves. But for this strategy to work, you should use the best research tools to increase the probability of success. In this regard, the MarketClub SmartScan tool in combination with their proprietary "Trade Triangle" filtering and ranking service, can give you a shortlist of top stocks whose market values are most likely to rise in the near term. For only $8.95 for the first month - it's worth a test-drive in my opinion.

Covered Call Strategies in a Bear Market

If the market as a whole has turned bearish, or you're a very conservative trader and want to stack the odds in your favour, you can still make a regular income with the right covered call strategies. In this case, the best alternative is to sell IN-the-money call options over your shares. The intrinsic value in your sold call options will work in your favour should the underlying price fall. If these options become OUT-of-the-money you will be able to buy them back for a much cheaper price than you sold them for, thus making a profit. In the meantime the extra premium you have received will provide a much greater buffer against falling share prices than out-of-the-money premiums.

Once the share price has fallen significantly (but not as low as your ITM call option strike price) you 'buy to close' the sold options and immediately sell MORE in-the-money calls at a still lower strike price. The profits you make 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 increase your returns.

And Sideways Markets

If you've observed a share price which is stuck in a narrow range and unlikely to move much either way in the short term, it's very likely that option prices will be cheaper due to low implied volatility. This will reduce your income, which is what you exchange for lower perceived risk. For stocks like these you should consider writing AT-the-money call options over the stock. You will receive more premium than for OTM calls and since the stock price isn't really going anywhere, you just 'rinse and repeat' each month until things change.

You can search for these type of stocks using a good stock and options screener, which most reputable brokers include with your account.

Bottom Fishing Stocks

We have dedicated a whole page to this subject, but the basic idea is, that you locate a solid company stock whose price has plummeted recently following an unfavourable news release or earnings report. You buy the stock at a discount by selling naked puts under it. Once you own the stock, you wait for the price to rise and then sell at-the-money or slightly out-of-the-money (depending on Implied Volatility) call options for income.

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

To explore these ideas in greater detail . . . . .

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