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Defensive Covered Call Strategy
The Smart Profits Report: Issue #293
Tuesday, March 21, 2006
Defensive Covered Call Strategy: What’s Better Than Making Money? Keeping It.
By Jim Stanton
Advisory Panelist, Mt. Vernon Research
I hate losing money - even more than I enjoy making it. And I’m sure many of you feel the same way. So, what can we do to avoid - or offset - our losses?
Well, we know that covered call writing is a way to generate additional income. But did you know you can put a defensive covered call strategy to work too?
It’s a strategy every investor should turn to when the market is experiencing a prolonged selloff or larger-than-expected drop. And here’s how it works…
Rising Markets Hinder Covered Call Writing
A defensive covered call option strategy works best in a stock market environment in which there’s not a lot of upside or downside. That’s because it’s a way to continually lower your average cost of the stock you own. You do that by collecting the premiums you receive for writing calls.
Rising markets can actually be a hindrance to covered call writing. That can force the covered call strategist to write calls too frequently. When that happens, the stock can get called away and the writer is faced with reinvesting money at potentially higher prices. That’s why timing is so important.
From October 1998 to March 2000, the S&P rose more than 60%. But if you were too active in your covered call writing, your return may have been considerably less than 60%.
In a falling market, short-term and intermediate traders can sell their long positions and either go short or wait for the next buying opportunity. But many long-term investors have a low cost basis on their stocks. They might not want to sell because of punishing tax consequences, and prefer to ride out the storm.
When you hear the Fed chief speak of “irrational exuberance” or you’re feeling exceptionally pleased with your portfolio’s performance and everyone is bullish, that may be the time to start thinking about protecting your gains. Here’s an inexpensive way to accomplish that.
Play Defense with Selling Covered Calls
To defend your portfolio in dramatic cases, like the 2000-2003 bear market, or in a prolonged correction, I would begin by selling covered calls.
Let’s assume the market is looking like it’s about to top out. And we want to lock in the gains we’ve racked up in, say, Proctor & Gamble (NYSE: PG). On March 17, 2006, PG closed at $59.10. We don’t want to sell a covered call that’s too close to the current price, so in this case, we’ll sell the PG October $65 call that’s trading at $1.
Pulling in an extra $1 per share is nice, but at times that $1 could be better spent on some insurance in case of a severe correction. The PG October $55 put is trading at $1.10. If we execute the trades at these prices, the insurance costs just 10 cents a share. If the stock goes up to $65 or higher, we’ve made an additional 10%. If the stock begins falling, regardless of how far down it falls, the maximum loss from its current level is less than 7%.
That’s a safety net that most investors would be pleased to have in a falling market.
Good Trading,
Jim
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Today’s Smart Profits Cribsheet
- For another good example of using covered calls, see Advisory Panelist Lee Lowell’s article, Selling Covered Calls - Getting Cash for Stocks You Already Own. Lee introduces ways to make some nice sideline income on your stocks.
- And don’t forget: In options, each “contract” controls 100 shares of the underlying stock issue. For other useful terms and phrases, like “covered calls,” see the Smart Profits Glossary.
Related Articles:
- IBM and Google Covered Calls: Tracking These 2 Giants For An Income Jolt
- Deep-In-The-Money Covered Calls - How to Beat Stocks with Less Risk
- Limit Order Discipline & Two Other Simple Rules For Making Money In Options
