We’ve talked about the seasonal effect that takes hold from May to November in the markets. This is a period of time when you will often hear the phrase “sell in May and go away.” And this is largely in part because it’s during this six-month period when the markets historically do not perform well (and sometimes perform the worst).
As you’ll recall, traders really don’t need to worry because we’ve got easy plays we can use to capitalize on the markets – whether they’re up, down, or sideways.
And as a rules-based options trader, I hardly have any equity positions, so I personally don’t have a bunch of stock to be concerned about in rough markets.
That being said, I realize I’m not necessarily the “typical” market participant, and you may likely be holding stock in your portfolio and retirement account. You may have even held stock for many, many years – through the good times and the bad.
But you do have an alternative to simply holding your stock.
And I’m about to show you a strategy that anyone with “optionable” stock can consider…
Consider Covered Calls When the Markets Meander
Now before we delve deeper, I must stress that I’m only suggesting that you consider this strategy as an alternative for your optionable stocks. I cannot recommend and am not stating that you should use this strategy.
What I want to do, instead, is talk about it with you. I strongly encourage you to discuss it with your broker, Certified Financial Planner (CFP), advisor, or all of the above to see if this strategy makes sense for your portfolio based on your short- and long-term goals, as you’ve discussed with them.
Now let’s get into it….
A covered call strategy is where you own the underlying asset (in this conversation, the stock), and you’re selling the right to buy your stock at a specific price on or before a specific expiration date. This strategy is among the simplest of options strategies, and it’s easy to understand – and execute.
You might consider a covered call if you were pretty neutral on the stock… meaning you don’t anticipate much of a movement – higher or lower.
According to the Stock Trader’s Almanac, the Dow Jones Industrial Average (DJIA) usually only averages a 0.3% return from May to November (which can be tracked back to 1950)… and you might not expect too many stocks to run very high either. The end result is that the market meanders sideways (which may be what stocks do as a whole as well).
As I mentioned above, this strategy is where the holder of the stock decides to sell a call option against at least 100 shares of that stock.
Now remember, one contract equals the rights to 100 shares of stock. So if you sell one contract, you are giving the markets the right to buy from you, or “call away,” 100 shares of your stock.
As the seller, you can sell a call for as far out as there are options written on that stock. A seller is also known as a “writer,” so when you’re selling a call against stock you own, you are “writing” a covered call. Typically, this is done on a stock that you feel will not move that much higher or lower, which I consider to be a stagnant or flat-trading stock. A stock that trades pretty much in a sideways range and has a tradable range between support and resistance levels is just fine.
Here’s an example of a sideways or range-bound stock, Linear Technology Corporation (NASDAQ: LLTC).
has rallied off the January lows like many stocks have. It’s been hovering at around $44 since March, with one attempt to pop higher in April that stalled out and came back to the $44 support level.
I’m using this stock to show you an example of a sideways, meandering-type, technical view. If you find yourself holding stocks that are behaving in a similar sideways, go-nowhere situation, this is the type of pattern that may benefit a covered call writer.
Writing covered calls can be done on a four- to six-week basis. As a result, if you choose to write covered calls, you can do so at a frequency where you can potentially earn money on a monthly basis.
Now if I look for an option that has a standard June expiration date (where the option expires on the third Friday of the month) and use the strike price just slightly out-of-the-money (where the strike price is higher than the current stock price), I’d be looking at the June 17, 2016 $45 Call.
The situation that could happen to you, as a covered call writer, is you get ‘”called out.” This simply means that the markets “call away” your stock at the strike price at which you sold the call.
In this case…
That would mean the markets bought the stock from you as the writer/seller of the call at $45 per share. As you know, one contract is equal to 100 shares, so in this case, the stock was sold at $4,500.
See what’s happening before that potential selling of the stock even takes place?
As the seller/writer of the call, you take in money just for putting the stock up for sale. Let’s say you get $0.75 for that option. That means you take in $75 per contract ($0.75 x 100 shares = $75).
Now this isn’t a screaming rate of return – about 1.7% or nearly 2% for a six-week return- but this wasn’t designed to be a money-doubler to begin with. This is a potential near 2% every month to month and a half on a stock that isn’t even really going anywhere (from your perspective as the covered call writer).
So what happens if expiration comes along, and the stock isn’t above the $45 strike?
Well, it isn’t likely to get called away. And as the holder of that stock, you’ve got the choice to look at the next four to six weeks out of options and do it again.
One other thing that may happen is that it does go above the $45 strike, and you do get called out.
Let’s say LLTC was bought at $44, giving you that $75 for the option. But then, it goes higher than $45, and the stock gets called away. In that event, you take in the extra $1.00, or $100 (buy the stock for $44 and sell -get called out- at $45 gives you an extra $1 per share).
The result is that you made $1.75 on a $44 investment, which takes the rate of return up to just under 4% – at 3.97%. Keep in mind that you’d have to decide to wait for LLTC to come back to $44 if you make the choice to try it again.
I reiterate that this is to be considered if you are holding a stock and do not expect it to move much, especially over this six-month, “sell in May and go away” period.
Three Rules You Should Know About Covered Calls
If you decide that covered call writing is for you, there’s three rules you should know … and stick to:
- Don’t write a call against a stock you do not want to sell. If you’re putting the stock up for sale, then the markets have the right to call it away from you.
- You can’t sell the stock unless the calls sold against it are closed or expire. This would leave you in an uncovered – or naked – position. Hopefully your brokerage won’t allow that to happen.
- You may risk selling a stock at a loss – even when writing calls against it. If you own a stock at $50 and write a $50 call, and it goes through a “bad” earnings report that drives the stock down to $35, you will not likely get called out. But… you still own the stock. And if you choose to write a call at a $35 or $40 strike and DO get called out, you may not offset the capital loss on the stock with the premiums you took in. And in this case, I refer you back to the first rule above.
At the end of the day, this strategy can be a great way to generate profits on a month to month and half basis (or however far out you write the calls) to get through this May to November period. This gives you the prospect of generating some income during a period in which you might otherwise be able to do little else than sit on your hands.
But it’s not for everyone…
If you don’t mind the prospect of your meandering stock getting called away from you (bought), this might be a strategy for you. Remember, there’s always the chance that it may not get called away, giving you another opportunity to try it again.
And that’s why I’ll remind you again to discuss this strategy with your broker, CFP, financial advisor, or all of the above before trying it out.
Here’s Your Trading Lesson Summary:
A covered call strategy is where you own the stock and sell the right to buy your stock at a specific price on or before a specific expiration date. This strategy is among the simplest of options strategies and is easy to understand – and execute. But you should always talk to your broker, Certified Financial Planner (CFP), financial advisor – or all three- before using it. And if you do, there are three rules you should know:
- Don’t write a call against a stock that you don’t want to sell
- You can’t sell the stock unless the calls you write against it are closed or expire
- You may risk selling the stock for a loss – even if you write calls against it
Have a great weekend!
P.S. Next week, we’re going to visit another strategy that’s very similar in concept – but doesn’t require you to own the stock. So stay tuned…