Most investors have enjoyed favorable portfolio gains during the recent bullish stock market activity and our covered-call portfolios have also benefited from rising share values. Unfortunately, the current rebound in share prices will not last forever and the cyclical nature of stock prices is one of the primary reasons the covered-call strategy can be very effective over the long haul.
While it is fairly easy for the average person to pick â€œwinnersâ€ in a flourishing economic environment, statistics suggest that relatively few participants are able to consistently time the market or predict the point at which a major trend will reverse. The directional approach to trading is difficult unless you monitor the market continuously, thus many prudent investors focus on achieving small but consistent returns with strategies where a successful outcome does not require long-term stock ownership or bullish price activity. One of the most popular tactics in this category, which involves the sale of deep-in-the-money calls against portfolio holdings, is not dependent on upward movement in the underlying issue and it also benefits from time-value erosion in option prices.
The Conservative Approach to Covered-Calls
The primary goal of investors who sell â€œin-the-moneyâ€ covered calls is to generate acceptable profits returns while still receiving an above-average amount of downside protection for unexpected declines in the stock. Rather than trying to find the chart break-outs, the trader who uses this approach is more interested in the overall technical outlook of the underlying issue for the duration of the option series chosen. His objective is to identify situations where there is a high probability of the stock price remaining above the cost basis (break-even point) of the combined position until option expiration and there is a favorable risk versus reward ratio with regard to potential profit and loss.
Regardless of the time-frame in which the in-the-money covered call strategy is applied, it requires at least a neutral-to-bullish outlook on the underlying issue and its sector industry or industry group. It is also important to consider upcoming events (earnings, FDA reviews, etc.) for the company and the trends of broader equity averages. If the overall market is due for a substantial correction or there is a potential catalyst for bearish activity (either of which could cause the stock price to fall below the cost basis of the position), then searching for a different candidate or waiting for a more optimum entry point may be the best course of action.
In those cases where the investor can tolerate longer term stock ownership, entry timing is less critical but is still important to identify the key trends and trade appropriately. Essentially, an investor begins selling calls against the stocks in his portfolio as they cycle through the first three stages of price activity (basing, breakout/rally, consolidation) and with the use of common technical analysis indicators such as oscillators or other timing signals, he attempts to improve the profit potential of a covered call play. Once an issue moves into the fourth or â€œbearishâ€ stage (which involves sustained distribution), the size of the holding is reduced to prevent capital losses.
Obviously, there are many ways to enhance the covered call strategy such as varying the option strikes and expiration dates or using different types of position management. The resulting outcomes depend primarily on each individualâ€™s personal preference and the manner in which he of she chooses to initiate and terminate covered call trades. A range of tactics for this strategy are identified in "New Insights on Covered Call Writing: The Powerful Technique That Enhances Return and Lowers Risk in Stock Investing." The book, which is co-authored by option guru Larry McMillan, is available in the OIN bookstore.