Call Options
Covered Calls Part III - Market Timing
By David Ondercin
Nov 11, 2006 - 8:53:00 PM

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.

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