How To Trade Covered Calls In Down Markets

Here are the practices for selecting stocks in periods of declining (not plummeting) markets, which have proven themselves over the years.

Stock Selection

Stick to the best companies, the ones people then want to own. These are the earnings superstars in industry groups that are least affected by the economic conditions then prevailing. If an industry group such as steel producers has been hurt and their fortunes turn for the better, then the best companies in the group can be considered.

Call Strike Selection

Writing deeply ITM strikes can work quite well if time value is good, and they can be rolled down with the stock’s decline. ATM calls deliver a higher return, but do not roll down so well, because they lose value much more slowly due to lower relative delta. Strike selection should be based on your assessment of the stock’s direction. Yet, during a hard market sell-off, almost no stock remains immune, so temper the writing of ATM calls – write the very strongest stocks only during brief reaction rallies.

The ITM writes are the gold standard during bearish periods, period.

OTM Calls

Though some stocks advance in a declining market, it is much harder for them to hold the advance. OTM writes should be considered only when an exceptional company in a strong industry group is advancing despite market conditions. Or better yet, save OTM writes on these high-strength candidates for the brief market rallies.

The Assignment Trap

Once a stock has declined more than 10% or is at a support level, be wary of writing a call that is several months out, particularly if the call is ATM or ITM. The reason is that a stock rebound will force you to buy back the short calls at a much higher price. What sometime hurts all the worse is that the stock’s rebound is a head-fake (stock soon fails and pulls back), which leaves the writer stuck with a higher cost basis from closing the short calls.

Rolling down too far also is a cause of being caught in this trap. Suppose you bought Nucor (NUE) at $44 in February 2009 and sold the 45 Call. Nucor then begins a fall to $30 by March 9th, and you roll the calls down repeatedly, perhaps even as low as the 25 Call. Nucor then charged back over $44. At some point you would have had to close the 25 Calls, which gain value almost dollar-for-dollar with the stock’s rise. Ouch. Even if you had, when Nucor was down to $30, written 35 Calls a few months out in time, you likely would still be writing a call strike below cost basis, and at some point even the multi-month 35 Calls would have to be repurchased at a loss – unless you were willing to gamble upon Nucor coming back down to that $35 strike price.

To minimize being caught in the assignment trap, never roll to a strike below a strong support level until the stock clearly seems to have broken that support. Remember the old saying: pigs get fat, hogs get slaughtered.

Rolling the Calls Down; or Down and Out

Rolling calls down means to buy back the short calls in the position and write new calls with a lower strike price in the same expiration month. Rolling them down and out means to write the new “replacement” calls in the next or a further expiration month. We roll down only on a stock that is falling, and rolling down lowers our cost basis, a key to successful covered writing. If the stock appears to catch its breath and re-advance once we have rolled down, however, we should close the short calls, let the stock recover and write the higher-strike calls again once the stock is higher. This is known as trading the calls and it can really juice returns.

Rolling calls down on a falling stock works best when the calls were written ITM in the first place. The reason is that ATM and OTM calls are much slower to lose value with the stock’s fall, due to their lower delta. This is yet another reason for ITM writing during bearish periods.

Collar Trade Strategy

A bearish environment is a logical place to deploy a Collar Trade protected covered call strategy discussed further on in this series of articles.

Though some stocks advance in a declining market, it is much harder for them to hold the advance. OTM writes should be considered only when an exceptional company in a then-strong industry is advancing despite market conditions. Better yet, do it during a market rally. This can hardly be described as a conservative practice, however.

  • Protective puts – Only the current- or next-month put has a high enough delta to be truly protective. The ITM put for the current month has the highest delta of all, but its high intrinsic value means that a stock snap-back will seriously erode its value. I typically buy only short-term puts and only when I am confident the stock or market is in a technical correction. Puts are no guarantee of profiting or protecting the stock in a declining market, any more than long calls carry a profit guarantee in a rising market. And when the stock is falling, volatility increases and so does the price of the put.
  • Collar Trade Strategy – The Collar Trade strategy, covered in detail further on, is made for declining markets.

I must emphasize that when the market is plummeting like a set of dropped car keys, there is no safe way to put on buy-write positions. And even the best companies likely will also sell off then. This is simply not a time to inaugurate a long stock position. This is, on the other hand, a great time to write deeply ITM calls on portfolio stocks that you intend to keep come hell or high water. The ITM calls are closed or rolled down as the stock falls.

Writing the Declining Stock: An Example

The secret to writing any stock and closing the trade profitably (and all covered writes are closed eventually, except those on long-term portfolio holdings), is to reduce cost basis in the position. At the trade’s conclusion, our final return will NOT be the stream of premium income generated, but the final selling price of the stock less our cost basis. That is, the final result of the trade will be the net of credits and debits, including trade costs.

Even if the stock is declining, we can write ATM and ITM calls as advantage appears, and even OTM calls occasionally, so long as we steadily reduce our basis and our basis is below market value. It is only when the stock price falls below our cost basis that the position is in trouble.

The following General Motors (GM) position conducted through calendar 2004 illustrates these dynamics. Though the table below shows a final return of $12.60, we did not actually close the trade until early 2005, losing about $3 of the $12.60 return. After it bottomed in 2005, we got back in and kept writing the stock for a few more months with excellent results. However, had we closed the GM trade in December as shown below the stated profit would have been the trade’s net result, not including commissions. GM, though hardly a poster child for great covered call writes, had been offering significant option premium and was at the time one of the world’s largest industrial corporations – a notion that today causes us to rub our eyes.

We began the trade in January 2004, purchasing GM at $54 and writing the ITM Jan-2004 50 Call (I was a bit bearish on GM) for a $5.50 premium.

In 2004, GM dropped from – approximately – $54 to $36.50, a fall of $17.50 (32%), and ended the year at $40.06, yet this trade made a great profit. It must be remembered that much of the 2004 market was a correction to the bullish movement of 2003. Though GM declined, so did most everything else. Here’s how it unfolded:

Figure 9.1

  GM Covered Call 2004 Debits & Net T.V.
Action Call Credits Premium Basis
1 Buy stock (54.00) -54.00
2 Write Jan-04 50C 5.50 1.50 -48.50
3 Called out of 50C 50.00 1.50
4 Buy stock again (53.80) -52.30
5 Write Feb-04 50C (stock=53.80) 50 5.60 1.40 -46.70
6 Write Mar-04 47.5C (stock=48.75) 47.5 2.90 1.65 -43.80
7 Write Apr-04 45C (stock=46.30) 45 2.90 1.60 -40.90
8 Called out of 45C 45.00 4.10
9 Buy stock again (46.25) -42.15
10 Write May-04 45C (stock=46.25) 45 2.95 1.70 -39.20
11 Write Jun-04 42.5C (stock=43.25) 42.5 2.25 1.50 -36.95
12 Called out of 42.5C 42.50 5.55
13 Buy stock again (ouch…) (47.70) -42.15
14 Write Jul-04 45C (stock=47.70) 45 4.30 1.60 -37.85
15 Write Aug-04 42.5C (stock=44.20) 42.5 3.45 1.75 -34.40
16 Write Sep-04 40C (stock=41.55) 40 3.20 1.65 -31.20
17 Called out of 40C 40.00 8.80
18 Buy stock again (41.85) -33.05
19 Write Oct-04 40C (stock=41.85) 40 3.40 1.55 -29.65
20 Write Nov-04 37.5C (stock=39.05) 37.5 3.05 1.50 -26.60
21 Called out of 37.5C 37.50 10.90
22 Buy stock again (38.90) -28.00
23 Write Dec-04 37.5C (stock=38.90) 37.5 3.10 1.70 -24.90
24 Called out of 37.5C 37.50 12.60
  Profit (Loss) $12.60 $19.10  

Analysis: The ultimate profit on closing was $12.60, the amount that total credits exceeded total debits, a 25.98% return for the year. Note that when I was assigned the last time on line 24, my basis was a positive $12.60. Thus the cost basis at any time is precisely the net debit amount the last column, or net credit amount if the trade is in profit. Note that the trade was in profit at several points earlier and could have been closed profitably. Even though GM dropped from $54 to $36.50 during the year, the mostly ITM call writes 1) produced good time value premium, and 2) kept lowering cost basis below the stock’s market price.

The Call column simply notes the short call open for the period. Net T.V. Premium notes how much of the total call premium was time value (the profit in the trade). The total of the net time value premium column is $19.10. But my profit for this stream of 2004 transactions was $12.60, not $19.10 – why? The reason is that at some points I added to my cost basis by repurchasing the stock at a higher price after being called out. In line 13, for example, I had just been called out at $40 and bought the stock again for $47.70; see how repurchasing the stock inflated basis – I might have been better to close the trade right there!

Every time I was called out of an ITM call and re-bought the stock, I added to basis. In fact, I would have been better off to roll the calls out or down in every case of assignment, since the cost is about the same to either close a deeply ITM call when the stock is higher at expiration or buy the stock again after assignment. But the net effect of ITM writes was to lower basis while pulling in great time value premium to create a profit.

Had the stock offered lousy time value premium, this story would not have ended so felicitously, of course. But GM had long been volatile enough to offer good premium, and there was no reason to think the party was about to end. Of course, at a point in 2005, GM went onto our “verboten” list and we have not written it since.

But back to the notion of lowering cost basis. This concept is so important that I want to state it as the Basis Rule:

“If we pull in enough time value premium and trade credits to lower cost basis faster than the stock declines, the write ultimately will be profitable.”

And if not, the position is a loser. If you learned this and nothing else at any covered call seminar, you probably would be good to go as a covered call writer.

Interestingly, the GM trade could have been far more profitable. I several times misjudged direction. And in several instances I should have rolled the calls out instead of allowing assignment but was lazy or not focused, because the position was going well. In hindsight when viewing a GM chart, some of the above writes and assignments are embarrassing; but though it could have been much better, it worked.

So the falling stock is not necessarily to be feared. GM was not doing well (still is not) and its long-term prospects were shaky. Had I foreseen just how bad things would get for GM, I probably would have been too cautious to write it. But as noted elsewhere in this series of articles, if you are considering a write on an unprofitable company, it should be one for which the expectations are lowered. It takes a lot to move the stock of a company this size. GM was at $54 at our position entry, but the market had sailed up since early 2003. We knew that GM could be taken down a peg, and we knew that the market would correct at some point.

Basically, the market had its eyes closed where GM was concerned. Due to such low expectations, the only things that reasonably would have taken it down were 1) massively bad news or 2) a market pulling back. Though it seems odd now, few really believed at the time that GM would come to its current pass. Still, had the stock stopped offering great premium, we would have exited the trade. But the continuing uncertainty about the company’s prospects and the market decline resulted in great premium.

But the volatility and therefore time value premium was great – and after all, it is General Motors. Only you can decide whether the stock’s rate of price decline will permit writing, but as this trade shows, it can work quite well.

>> How To Trade Covered Calls In A Bear Market

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