Covered Call Strategies for All Market Conditions
Covered call strategies are liked by options sellers because of their capacity to produce consistent profits over time. In markets that advance or trade sideways, the call option premium supplies the income, and in falling markets, this aforesaid premium offsets the losses. Stock investors have used covered calls for in excess of 30 years. They're so well liked 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 create optimal returns from covered calls, it's generally recommended to apply them to stocks and shares with a significantly greater historical volatility. Even though this seems to be rather counterintuitive, studies have shown and even Warren Buffett has commented that there is "no correlation between beta and risk". The main reason why these volatile stocks can be so appealing is that they're capable of returning 40%+ each year - not necessarily on the grounds that stock price is going to rise noticeably but because the inflated option prices reflect the outlook for underlying stock volatility.
But covered call strategies also contain a measure of risk so we need to apply the right approach to varying market conditions. The least favourable scenario happens when you acquire a stock, sell out-of-the-money covered calls at exercise prices higher than the buying price and next thing the very same stock price takes a big plunge. In these situations, the option premium you've just received will probably not offset the capital loss on the shares themselves.
Then what can one do?
Your original sold OTM calls are going to be significantly devalued at this point, and that means you could repurchase them 'for peanuts' and straight away sell more at a lower strike price. This will pull in further premium to counterbalance the capital loss on the shares. However, if you're relying on covered call methods for a consistent income you won't make anything on those shares this month and should the price continue to fall, you may even have to accept a loss.
So although selling OTM covered calls is great for a sideways or bullish outlook for a given share, it might not be the best plan when they're around their price peaks. You could buy protective OTM put options at strike prices below the share purchase price but this would reduce your overall earnings. Protective puts are a more desirable choice when you are more "investor" than "trader" minded and propose to retain the shares for a while.
Neverthelss, in a bullish trend, OTM covered calls yield the most beneficial outcome - you receive option premium and also a capital gain on the shares themselves. But for this plan to work, you should use the best research tools to increase the chances for success.
How About a Bearish Market?
When the market has turned bearish, you can still actually make a consistent income using the right covered call techniques. Here, the most suitable approach would be to sell IN-the-money call options on your shares or commodity futures. The intrinsic value in your sold call options will work advantageously should the underlying price fall. If these options transform into OUT-of-the-money you will be able to buy them back at a much cheaper amount than you sold them for, thus receiving a profit. Meanwhile the extra premium you have received from the ITM options will give you a far greater buffer against decreasing share prices than out-of-the-money premiums.
Once the stock price has fallen significantly (but not as far as your ITM call option exercise price) you 'buy to close' the sold options and without delay 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 at the time are volatile could also include some favorable implied volatility to increase your returns.
And Consolidating Markets
If you've found a share price which is stuck in a range or sideways channel and not likely to move much up or down in the short term, it is quite likely that option prices are going to be under priced because of low implied volatility. This will reduce your potential earnings, which is what you exchange for lower perceived risk. For stocks such as these you should think about selling AT-the-money call options over the stock. You can expect to receive more premium compared to OTM calls and as the stock price isn't really moving much, you just 'rinse and repeat' month after month until things change.
You can search for these kind of stocks with help from a good stock and options screener, which most reputable brokers include as part of your account.
Making consistent returns from covered call strategies is only a matter of deciding what risks and returns you're happy with and then applying the most effective method.
