Covered Call Ideas for All Market Conditions

Covered call techniques are well favored by options traders due to their capacity to generate regular profits over time. In markets that rise or trade sideways, the call option premium delivers the income, while in falling markets, this same premium offsets the losses. Investors have used covered calls for in excess of 30 years. They're so well liked that in 2002 the Chicago Board Options Exchange announced the original key benchmark index for covered call strategies - the CBOE S&P 500 BuyWrite Index (code BXM).

To create the best possible yields from covered calls, it's generally necessary to apply them to stocks and shares with a considerably greater historical volatility. Even though this seems to be somewhat counterintuitive, studies have 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 because the stock price is about to rise noticeably 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 so we ought to apply the appropriate course of action to varying market conditions. The bleakest scenario happens when you acquire a stock, write out-of-the-money covered calls at exercise prices higher than the buying price and next thing the very same stock price has a big dive. In these situations, the option premium you have just received will most likely not offset the capital loss on the shares themselves.

Then what can one do?

Your original sold OTM calls will undoubtedly be significantly devalued at this point, so you could repurchase them 'for a song' and then sell additional call options at a lower exercise price. This would pull in further call option premium to offset the capital loss to the shares. But if you're depending on covered call strategies for a consistent source of income you won't be making money on those shares this month and should the price continue to fall, you may even have to take a loss.

So while writing OTM covered calls is ideal for a sideways or bullish outlook for a given share, it might not be the best choice if they are around their price peaks. You could pay for protective OTM puts at strike prices beneath the share purchase price but this would reduce your overall earnings. Protective puts are a better choice when you are more "investor" than "trader" oriented and propose to hold the shares for a while.

Neverthelss, in a bullish trend, OTM covered calls give the most beneficial result - you will get option premium and then a capital gain on the shares themselves. But for this strategy to work, you need to use the best research tools to raise the probability of success.

How About a Bear Market?

If the general market condition has become bearish, you can make a consistent income when using the appropriate covered call solutions. In this case, the most suitable solution is to sell IN-the-money call options for your stocks or commodity futures. The intrinsic value in your sold call options will work to your advantage should the underlying price fall. If these options become OUT-of-the-money you'll be able to repurchase them at a much cheaper amount than you sold them for, thus receiving a profit. At the same time the extra premium you have gained from the ITM options will give you a much greater buffer against decreasing share prices than out-of-the-money premiums.

When the share price has fallen significantly (but not under your ITM call option strike price) you 'buy to close' the sold options and straight away sell MORE in-the-money calls with a still lower exercise price. The gains you will be making under these conditions are thanks to the 'time value' of the options which, if prices have become volatile may also include some strong implied volatility to increase your returns.

And Sideways Markets

If you've observed a share price which is stuck in a range or sideways channel and unlikely to move much either way in the short term, it's very probable that option valuations will be cheaper due to low implied volatility. This will lower your potential earnings, which is what you exchange for lower perceived risk. For stocks like these you should consider selling AT-the-money call options over the stock. You'll receive more premium compared to OTM calls and as the stock price is not really moving much, you just 'rinse and repeat' month after month until things change.

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

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