Covered Calls
Part III - Market Timing
In Part I we discussed
the advantages of the Covered Call Strategy and how it is possible to make a lot
of money. In Part II we analyzed the risks and potential downside of this
trading strategy. In Part III we will examine the best market situation to put
on Covered Call Trades and when to avoid this strategy.
Perhaps the best market
environment in which to place Covered Call trades is in a mildly bullish to
bullish environment. This idea seems contrary to conventional wisdom that
considers Covered Call trades best during neutral to bearish markets. Well,
contrarianism is a good posture to have toward the financial markets. At the
time of this writing, the Dow Jones Industrial Average has lost over 600 points
in the space of two weeks. Had you placed a Covered Call Trade two or more weeks
ago, you could be a very unhappy person. It is conceivable that your underlying
security might take months to recover from such a large swing in the market.
What can you do? Is there
a safer way to place Covered Call Trades and generate income on a monthly basis?
Yes, there is, but is takes some work, skill, and nimbleness.
In a previous paragraph
above I mentioned that you should consider Covered Call trades a "bullish"
strategy. Our first concern is to protect your capital. To protect out trading
account, we are looking for stocks or securities that are bullish to neutral.
The logic is obvious, in that your purchase of the underlying stock or security
will be holding its value or rising. Directional trading becomes your safety net
provided the security maintains its price value.
If you invest using
Fundamentals, then, of course, Due Diligence is required when considering
purchasing the underlying security. If you prefer Technical Analysis, as we do,
base your purchase on support and resistance. Determine if the stock is likely
to stay within your support and resistance zone and place your entry within the
zone. In a bullish market, you will want to buy the stock on a pullback so that
the stock will become profitable as soon as it emerges from the pullback.
What can you do if the
stock plummets below your support zone? It may simply pop back into the zone
after a couple of days and you are okay. Or, instead of simply piercing support,
it drops right through and looks like it is heading further south. What are your
alternatives? As you can see, there are numerous alternative choices a trader
could make. A discussion of the advantages and disadvantages of the best
alternatives are beyond the scope of this paper. However, we can entertain
several ideas of what to do when your Covered Call trade goes askew.
By the way, if you are
going to trade and trade Options as well, then you really need to have a plan
for as many contingencies as you can. A person relatively new to trading should
actually write down what to do if "A" happens, "B, C", or "D" etc. This must be
done before you place the trade, not when it happens.
Okay, what might you do
if your underlying stock heads south? Have a Stop Loss in place. It will protect
your capital while the market is open. If the stock takes out your stop, then
you have minimized your loss on the underlying security. You should also buy
back the Call you sold because your short Call will be "naked." If the stock
takes out your stop loss, then you will probably be able to buy back the Call
for $.05 or $.10. Your overall net loss will likely be small.
However, if the stock
gaps down in pre-market, then you won't have a Stop Loss in place for
protection. In that case, you can exit when the market opens, or wait to sell
after the first half-hour when stocks normally rebound from their lows. As you
can see, the risks associated with trading Covered Calls are real and they can
be potentially devastating.
At Options Mentoring, we
will teach you the defensive postures you need for trading various Options
strategies, and we will teach you, step-by-step how to make money trading
Options. Click here to learn about our incredible course: Trading Stock Options
the Easy Way.
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