Covered call writing is a stock option strategy with primary goals of income generation and capital preservation. Most of us are conservative investors who use the power of education to master an investment strategy better than most everyone else using the same strategy. That is what the Blue Collar Investor is all about.
In the past few weeks, I have heard from many of our member (international members as well) who are concerned about a severe market correction and want to be prepared in case a significant downturn does take place. Although I do not personally share this degree of concern, I do feel that a review of some of the management techniques we can implement in the event that the market corrects to a significant extent:
Sell in-the-money strikes
Using in-the-money strikes is our most commonly used approach to protecting ourselves against share depreciation. We are generating downside protection of the time value of the premium, a perk paid for by the option buyer, not us. If we sold a $30 call on a stock currently trading @ $32 for $3, our initial profit is 3.3% ($1/$30) and that profit is protected by the intrinsic value ($2/$32) = 6.25%. In other words, our share price can drop by 6.25% and we would still generate a 3.3%, 1-month return.
Use low-beta stocks
Our premium watch list gives beta stats and historically low-beta stocks tend to outperform in bear market situations.
Lower monthly goals using options with less implied volatility
As an example, lower your monthly goals for initial returns from 2-4% to 1-3%. This means that the implied volatility of the underlying securities is less and therefore carries lower risk.
Use ETFs instead of stocks
ETFs or exchange-traded funds are baskets of stocks with some going up and some going down. As a whole, and generally speaking, these securities have less implied volatility (IV) than individual stocks. In our weekly ETF Reports for premium members we also give IV stats for our ETFs and you can tailor your portfolio to your personal risk tolerance and overall market assessment. Here, too, I would lower my goal to perhaps 1-2%.
Buy protective puts
A put will give us the right, but not the obligation, to sell our shares at a certain price. When used in conjunction with covered call writing, the strategy is called the collar strategy. It usually is set up by selling an OTM call and buying an OTM put. Here’s an example:
- Buy BCI @ $48
- Sell the $50 OTM call for $2
- Buy the $45 OTM put for $1
Our initial options credit is cut in half but we are protected against a catastrophic price decline below $45.
Sell cash-secured puts
We can enter our covered call positions “at a discount” if we are bearish on the overall market. Here’s an example:
- BCI is trading @ $42
- Sell the OTM $40 put for $1 = 2.5% return
- Each put contract is secured with $4000 in cash
- If there is a price decline below the $40 strike, we purchase BCI at a cost basis of $39 ($40 strike – $1 premium)
- We can now write a call on this stock and select a strike based on all the parameters detailed in my books and DVDs.
I call this the PCP Strategy or Put-Call-Put Strategy. To better visualize this strategy here is a diagram:
I will be discussing this strategy along with many other put-selling strategies in my upcoming 5th book about puts, now being edited.
One of the advantages of covered call writing is that it can be molded and modified to meet the challenges of current market conditions. An elite and educated covered call writer, which is where I want all of you to be, will change the strategy approach based on overall market assessment, chart technicals and personal risk tolerance. One size does not fit all.
4 new events added this past week:
I accepted 4 new invitations this past week that we can add to the BCI event calendar:
July 17, 2014: eTrading Expo webinar: 1:50 – 2:50PM ET
November 21, 2014: Las Vegas Trader’s Expo
June 13, 2015: Raleigh/Durham, North Carolina (AAII)
September, 2015: Saint Louis, Missouri (AAII)
For a complete list of all BCI events taking place in 2014 and 2015 click on the link below (view both pages):
Despite disappointing retail sales statistics, this week’s reports had a bullish sentiment for continued economic expansion:
- Retail sales rose by 0.1% in April, well below the 0.6% analysts were expecting
- New residential construction in April increased by an impressive 13.2% for an annual rate of 1.1 million units far above the 980,000 projected by economists
- Housing starts are up 26% from April, 2013
- The Producer price Index (a measure of the average change over time in the selling prices of a fixed basket of goods by stage of production, industry, and commodity. It is considered a leading indicator for consumer inflation) rose by 0.6%, double the 0.3% anticipated
- The Consumer Price Index (a widely followed indicator of inflation. The CPI is a measure of the average change over time in the prices paid by urban consumers for a fixed market basket of consumer goods and services) rose by 0.3% in April, as predicted. Despite these increases many of the forces that drive up inflation are below historical levels
- Industrial Production dropped by 0.6% in April far below the +0.2% expected. This followed a huge rise of 0.9% in March and many economists felt that the recent levels were not sustainable
- Business inventories (an important indicator of the near-term direction of production activity) moved up by 0.4% in March, as expected
- Initial jobless claims for the week ending May 10th came in at 297,000 below the 317,000 expected
For the week, the S&P 500 was flat for a year-to-date return of 2%, including dividneds.
IBD: Market in correction
BCI: This site remains bullish on the overall economy. This was confirmed by the positive housing data and respectable earnings reported in the recent quarter. Earnings increased by an average of 5% for S&P 500 companies and sales grew by 2.8%. The average S&P 500 company beat consensus estimates by 6% according to Bloomberg. However, because of recent market volatility, we are taking a relatively conservative stance and selling an equal number of in-the-money and out-of-the money strikes.
Continued success to one and all,
Alan ([email protected].com)