Notice that this section refers to declining markets, not necessarily a secular bear market. Just as there can be substantial, multi-month up-legs during a bear market (known as bear rallies), there can be lengthy down-leg corrections in a good market.
Something that continues to amaze people is that covered calls can be written in most markets, including a market that is generally declining. Mind, they should not be written in a market that is selling off heavily, such as October and November of 2008.
Short-sellers can usually find good trades in a rising market, though it takes more work. Is it really so surprising that covered calls can be written in declining markets? This article will explore techniques for writing them, after looking at the different market environments that fall under the rubric “declining” market.
A healthy bull market corrects periodically, partly because traders (all of whom are seeing the same charts as you) expect a pullback, and partly because traders and investors take profits. When profit-taking reaches extreme levels, the market tops and sells off. When buyers gain confidence that the market has sold off long enough and begin re-entering the market, the buying slows the decline. The buying eventually overpowers selling, and a new advance begins which recovers the lost ground. The correction can easily be 10-12%, which is no laughing matter. These corrections typically will last two to three months. Examples include the February-March and July-September corrections in 2007.
The same thing happens to stocks, individually. This is why stocks periodically pull back to the 50-day or other reactive moving average, or trend line, test support there and recover – which is why support and resistance levels are so important to the covered writer. Investors take profits and the stock sells off, until enough buying by bargain hunters ends the decline and causes the stock to rebound. During a good market, an excellent company will rebound, unless its fundamental picture changes, which really means that its earnings outlook changes, for whatever reason(s).
Corrections are healthy, though they can be worrisome beasts. When the market or stock has risen significantly without a correction, we can assume one is due. When the economy and corporate earnings remain strong, I treat these market pullbacks as corrections.
Lengthy Range or Correction
These are periods of lengthy consolidation (trading range) periods in a bull market, and the trading range can be a declining one. Examples include the market’s declining trading range from March-October 2004, July-December 1997 and the long flat trading range through the first half of 1996. I treat these as consolidation periods if the overall economy and corporate earnings remain solid.
One’s call writes need to be adapted to the range waves, of course. For example, at range tops the deeply ITM calls are best written, and OTM calls during an up-wave. It helps greatly to view a weekly as well as daily chart to get a feel for the range.
Secular Bear Market
This is the real thing, a bear market that lasts for years, such as 2000 through 2002, and late 2007 though to April 2009. Bear markets are viewed as periods of falling markets, and long, frightening drops do indeed occur. But they also are characterized by periods in which the market tends to be flat and rather lifeless, as well as lengthy periods of advances, the bear rallies. During such rallies, it is not unusual to see massive speculation in the financial press whether a new bull market has begun.
As an income investor I don’t fear bear markets; just another day at the office. I tend to view bear markets very technically, writing OTM calls when the market is surging and ITM or ATM calls when it is not. This is easier said than done, though, because some bear rallies are so short-lived (three months, for example) that by the time we realize the rally is on, it is nearly over! Bear markets also are a great time for a Collar Trade strategy for defining and limiting trade risk, discussed in a subsequent article.
Consider this: the bear market that began in 2007 resulted in a drop of approximately 56% from October 2007 though March 2009. However, that period did not result in a uniformly steady decline; markets only do this when selling off hard. Consider these factors:
- During this period, the market was punctuated by both flat and rising indices.
- Except during a hard decline, there always are rising stocks and industry groups that are stronger than the market indices.
- It is possible to find deeply ITM writes on great companies that are showing more strength than the market, often times with huge downside protection.
- Due to increased volatility and higher overall expectations of volatility, premium tends to be higher.
- Technical writes are possible during a market advance following a pullback. Since markets don’t usually go straight down in bear periods, the major indices will decline to a trend line and then advance again. I will put on ITM writes at this point to get extra protection. Those less risk-averse can write ATM or even OTM, and such writes on companies stronger than the overall market can do quite well.
All serious declines, regardless of length or amplitude, have one thing in common: there occurs a flight to quality. Investors, professionals and institutions all tend to bail out of the lower-quality stocks and flee to those of higher quality. The flight to quality is why the better companies (measured by earnings quality and growth) do best in corrections and declines and come back soonest. And it’s why the weaker, less-desirable stocks sell off even harder.
If during a market sell-off you’re caught in a company that is small, highly overvalued, unreliably volatile, unprofitable (or worse, lacking revenues entirely), in a weak industry… you have selected stocks with several of the 9 danger signs discussed earlier. The stocks that are the least reliable for covered writing can become positively toxic when the going gets rough.
And without a doubt, there is a great deal of industry sensitivity to economic conditions. When the economy is struggling, auto sales and discretionary consumer goods, for example, will falter. By extension, so will steel producers and heavy-equipment manufacturers. Nowhere is it truer than in a declining market that we should look for the best companies in the best industries and the best sectors.