Covered Call Guidelines for All Market Conditions

Covered call strategies are enjoyed by options sellers due to their ability to bring in consistent profits over time. In markets that rise or trade sideways, the call option premium provides the income, and in falling markets, this aforesaid premium offsets the losses. Traders have used covered calls for more than 30 years. They're so well received that in 2002 the Chicago Board Options Exchange launched the original key benchmark index for covered call strategies - the CBOE S&P 500 BuyWrite Index (code BXM).

To earn the best returns from covered calls, it's generally recommended to apply them to stocks and shares with a considerably greater historical volatility. Even though this seems somewhat counterintuitive, research shows 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 for the reason that inflated option values reflect the outlook for underlying stock volatility.

But covered call strategies also carry a measure of risk therefore we need to employ the best course of action to varying market conditions. The worst case scenario happens when you buy a stock, sell out-of-the-money covered calls at exercise prices above the buying price and next thing the same stock price has a big plunge. Under these scenarios, the option premium you've just received will most likely not offset the capital loss on the shares themselves.

Then what can you do?

Your original sold OTM calls will undoubtedly be significantly devalued by this time, so you could buy them back 'for a song' and straight away sell additional call options at a lower strike price. This will pull in even more call option premium to further offset capital loss to the shares. But if you're relying on covered call methods for a consistent source of income you won't be making money on those shares this month and if the price continues to decline, you may even have to accept a loss.

So while writing OTM covered calls is great for a sideways or bullish outlook for a given share, it might not be the best idea when they are near their price peaks. You may choose to pay for protective OTM puts at exercise prices lower than the share purchase price but this will reduce your overall returns. Protective puts are a more effective strategy when you are more "investor" than "trader" minded and intend to hold the shares for a while.

Neverthelss, in a bullish trend, OTM covered calls yield the best result - you receive option premium and also a capital gain on the shares themselves. But for this plan to be effective, you should employ the best research tools to raise the probability of success.

How About a Bearish Market?

If the market has turned bearish, you can make a consistent income when using the right covered call solutions. Here, the most suitable approach is to sell IN-the-money call options over your shares or commodity futures. The intrinsic value in your sold call options will function in your favour should the underlying price fall. If these options transform into OUT-of-the-money you will be able to buy them back for a far cheaper price than you sold them for, thus receiving a profit. In the meantime the extra premium you have gained from the ITM options will provide a much greater buffer against decreasing share prices than out-of-the-money premiums.

In the event the share price has fallen substantially (yet not as far as your ITM call option exercise price) you 'buy to close' the sold options and immediately sell MORE in-the-money calls with a still lower strike price. The profits you're making under such conditions are from the 'time value' of the options which, if prices have become volatile may also include some favorable implied volatility to enhance your returns.

And for Sideways Markets

If you've noticed a share price which is caught in a range or sideways channel and not likely to move much either way in the short term, it's very likely that option valuations will be cheaper on account of low implied volatility. This will lower your potential income, but that's what you exchange for lower perceived risk. For stocks like these think about writing AT-the-money call options on the stock. You will receive more premium than for OTM calls and as the stock price isn't really moving much, you simply 'rinse and repeat' month after month until things change.

You can look for for these type of stocks with help from a good stock and options screener, which most decent brokers incorporate with your account.

Earning consistent returns from covered call strategies is only a question of identifying what risks and returns you're comfortable with and then implementing the appropriate method.