Covered Call Recommendations for All Market Scenarios

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Covered call techniques are liked by options traders because of their ability to produce regular income over time. In markets that go up or trade sideways, the call option premium gives you 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 popular that in 2002 the Chicago Board Options Exchange announced the first major benchmark index for covered call strategies - the CBOE S&P 500 BuyWrite Index (code BXM).

To earn the best yields from covered calls, it's generally recommended to apply them to stocks and shares with a considerably higher historical volatility. Although this seems somewhat counterintuitive, research has shown 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%+ each year - not necessarily on the grounds that stock price is preparing to rise dramatically but for the reason that overpriced option values reflect the expectations 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 least favourable scenario occurs 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 cases like this, the option premium you have just received will most likely not offset the capital loss on the shares themselves.

Now what can you do?

Your original sold OTM calls are going to be significantly devalued by now, and that means you could repurchase them 'for peanuts' and immediately sell more at a lower exercise price. This would pull in additional call option premium to counterbalance the capital loss on the shares. However, if you're relying on covered call strategies for a consistent cash flow you won't be making anything on those shares this month and if the price continues to decline, you may even have to accept a loss.

So although writing OTM covered calls is great for a sideways or bullish view for any given share, it might not be the best practice when they're around their price peaks. You may choose to pay for protective OTM puts at exercise prices lower than the share purchase price but this would lower your overall returns. Protective puts are a more desirable choice if you're more "investor" than "trader" oriented and propose to keep the shares for a while.

Neverthelss, in a bullish trend, OTM covered calls yield the most beneficial result - you will get option premium and also a capital gain on the shares themselves. Nevertheless for this strategy to work, you should employ the best research tools to increase the probability of success.

What About a Bear Market?

If the general market condition has turned bearish, you can make a regular income utilizing the right covered call techniques. In this case, the most effective alternative is to sell IN-the-money call options for your shares or commodity futures. The intrinsic value in your sold call options will work to your advantage should the underlying price fall. If these options come to be OUT-of-the-money you will be able to buy them back at a far cheaper price than you sold them for, thus receiving a profit. At the same time the extra premium you have obtained from the ITM options will furnish a far greater buffer against decreasing share prices than out-of-the-money premiums.

In the event the stock price has fallen substantially (yet not under 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're making under such conditions are courtesy of the 'time value' of the options which, if prices have become volatile could also include some strong implied volatility to increase your returns.

And Consolidating Markets

If you've found a share price that is caught in a range or sideways channel and not likely to move much up or down in the short term, it's very probable that option prices are going to be under priced because of low implied volatility. This will lower 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'll receive more premium compared to OTM calls and because the stock price is not really going anywhere, you simply 'rinse and repeat' month after month until things change.

You can search for these kind of stocks with the assistance of a good stock and options screener, which most reputable brokers incorporate as part of your account.

Earning steady returns from covered call strategies is simply a matter of deciding what risks and returns you're happy with and then applying the most effective method.

Owen has traded options for many years and writes for Options Trading Mastery, a popular site about profitable Option Trading Strategies. Discover a wealth of information about options, including the best Covered Calls strategies.

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