Covered call writing is applicable only in neutral to slightly bullish market environments”. We’ve heard this proclamation time and time again and so it has become accepted as fact to a majority of option-sellers. In this article, we will examine the reasons for the allegation and investigate a completely new viewpoint as to when covered call writing can be implemented to our advantage.
Reasons why many believe covered call writing is useful only in neutral to slightly bullish markets
Profit & Loss Graph
This chart shows limited upside potential with unlimited downside risk, seemingly perfect for neutral to slightly bullish markets only. Let’s say we buy a stock for $29.00 and sell the $30.00 call option for $0.75. Our maximum profit is $1.75, $0.75 on the option side and $1.00 on the stock side. Our breakeven is $28.25 ($29.00 – $0.75). The graph tells us that we can generate $1.75 in profit but lose $28.25 per share, not a pretty picture on first glance. Furthermore, if the stock price moves past the strike by more than $0.75, we “start losing money” Let’s say the price moves to $33.00, $4.00 higher than purchase price. We could have made $4.00 profit but only generated an earnings of $1.75…we “lost” $2.25 the thinking goes.
When to use covered call writing: An alternative perspective
In my humble opinion, covered call writing is appropriate in all but the most extreme market conditions. This means that it is appropriate in more than 95% of all market environments, probably more. The reason is that the strategy can be tailored to specific market conditions. Most covered call writers, buy a stock, sell a slightly out-of-the-money strike and wait for results. That IS the above graph. That IS NOT the Blue Collar way. Let’s dismantle the old way of thinking.
Limited upside potential
This is true however in bull market environments we can raise the level of the strike price and allow for additional share appreciation. It is true, this would mean a lower premium on the option side but would absolutely enhance the opportunity for greater returns by adjusting the strike price.
Unlimited downside risk
This is wrong on three fronts:
- The premium itself represents a degree of downside protection
- We can use in-the-money strikes in bear and volatile markets to gain additional downside protection in the form of intrinsic value. This additional protection is paid for by the option-buyer, not by us.
- There is an absurd assumption here that no action will be taken if share price declines…ridiculous. Every strategy we use to invest our hard-earned money must have a position management component in the form of exit strategies. These are stressed and detailed in my books and DVDs
Here’s what the profit & loss graph should look like:
We start losing money when share price moves past the strike by more than the option premium
Every strategy should have its goals and exit plans. For example, we may set a goal of 2% – 4% per month for initial returns in hopes of achieving even higher returns in neutral to bull markets when selling out-of-the-money strikes. Let’s go back to our example of buying a stock for $29.00 and selling the $30.00 call for $0.75 only to see share value move to $33.00. Here’s my new-perspective take: We generated $1.75 in profit on a cost basis on $29.00 for a 1-month return of 6.03%. We have achieved our goals for the strategy we have selected. At this point, we may decide to roll the option or allow assignment. That’s part of our position management arsenal. From a philosophical and financial viewpoint we succeeded dramatically. It makes no sense to say that if we used a different strategy we could have made more money. We succeeded, we didn’t fail.
There is no one strategy that is right for every investor. When making a decision, however, we must understand all the nuances, pros and cons, of each approach. For covered call writing, we can adjust the investing parameters to meet most market environments, mitigate losses and enhance gains. The fact that we are exposed to statements regarding these strategies over and over again does not mean that they should be fully embraced and never challenged.
May live events
Caesar’s Palace- Las Vegas
Global stocks declined this week due to signs of sluggish global economic growth. The Chicago Board Options Exchange Volatility Index (VIX) fell on the week to 14.72 from 16.26. Crude prices dropped to $44.35 from $46.22 a week ago, and global Brent crude prices fell to $45.03 from $48.11. This week’s reports and international news of interest:
- The US Department of Labor released a disappointing employment report on Friday. Nonfarm payrolls rose 160,000, falling short of the 200,000 consensus
- Downward revisions to the prior two months’ data trimmed a further 19,000 jobs
- The unemployment rate held steady at 5.0% while the participation rate dropped to 62.8% from 63.0%
- The one positive note in the report was a 2.4% rise in average hourly earnings on an annual rate
- Futures markets are now pricing in a 4% chance of a Fed rate hike next month
- Crude oil production near Fort McMurray, Alberta, Canada, has been severely disrupted and nearly 90,000 inhabitants have been evacuated as a result of massive wildfires in the region. It is unclear how long production will be shut in or how big an impact this will have on the Canadian economy
- Puerto Rico’s Government Development Bank defaulted on $422 million in municipal bonds this week, setting the stage for a larger default on 1 July, when nearly $2 billion in general obligation bonds come due
- J.P. Morgan’s composite global manufacturing purchasing managers’ index, US manufacturing expanded less vigorously in April, as did manufacturing activity in China, the United Kingdom and Japan
- The Australian central bank unexpectedly cut policy rates this week to 1.75% from 2.0%. The policy rate now stands at the lowest on record The Australian dollar fell sharply in the wake of the announcement.
- The EC reduced its 2016 GDP forecast to 1.6% from 1.7% and cut its inflation outlook to just 0.2%, well below the 0.5% February forecast. Also this week, the European Central Bank’s monthly bulletin indicated that economic risks remain tilted to the downside
THE WEEK AHEAD
- China reports trade data and foreign exchange reserves on Monday, May 9th
- Eurogroup finance ministers meet on Monday, May 9th
- China releases consumer and producer price data on Tuesday, May 10th
- US retail sales figures are reported on Friday, May 13th
- China reports retail sales figures on Saturday, May 14th
IBD: Uptrend under pressure
GMI: 2/6- Sell signal since market close of May 4th
BCI: Neutral selling an equal number of in-the-money and out-of-the-money strikes. Recent economic data has been leaning bearish and recent earnings season was unimpressive.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
Alan ([email protected])