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Take Advantage Of Covered Call Strategy On Market Slide

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It's time to start thinking about covered calls with the recent market selloff spiking in implied volatility (IV) on options across the equity market, presenting us with a Theta-catching opportunity. Covered calls will allow you to capture returns on stocks you already own or buy new shares of enterprises you've waiting to acquire at a discount.

What's A Covered Call? 

Implementing a covered call strategy involves selling out-of-the-money call options on a stock that you own or want to purchase and collecting the premium that each call option yields you. This means that you are effectively sell-short the options contract. Your P&L on this options play would be inverse to the call's premium. However, the underlying shares that you own protect you from any losses (aka covered call), making these trades risk-free (if you don't account for opportunity losses if the underlying stock soars above your strike).

When executing a play like this, you have to remember that each option contract represents 100 shares. Meaning you should only write (or sell) call contracts for each block of 100 shares that you own or would like to own.

Theta is the per-share value an option will lose each day if the underlying security does not move. Theta as a percentage of an option's premium is what we are most focused on with this strategy. The higher the relative theta, the larger your potential gains will be. Theta (quoted as a negative figure) and implied volatility are directly correlated on an absolute value basis. 

Risk Of Writing Uncovered Call

Selling call options is extraordinarily dangerous if you don't own the underly security because your downside is unlimited.

To help you conceptualize this, imagine you sold a 1-Year out Alphabet (GOOGL - Free Report) call in September 2020 for a September 2021 monthly contrat (Sept 17th Exp.) at a $2,500 strike for a quoted $20 per share premium, with zero shares held.

Now, most people in their right mind would think that there is absolutely no way that GOOGL, trading at $1,450 a the time, would be able to rally over 72% in the next year. Perceptively it was a 'low-risk trade,' despite not owning the $145,000 worth of stock needed to make this trade truly risk-free (100 shares).

This trade would have provided an immediate credit of $2,000 ($2,000 premium x 100 shares = $10,000), but as GOOGL rallied, your position would have quickly turned against you. Since you are short the call, every dollar the premium moves up is a dollar against your position as you would have to repurchase the call at market value to flatten your trade.

Let's say you held on to this until it expired last month, assuming you didn't have the required shares on hand, you not only would have lost the entire $2,000 premium that you were credited a year prior but would now have to pay the difference between the $2,500 strike and $2,816 spot price of the stock. This would have run you $31,600, (($2,816 – $2,500) x 100 = $31,600).

This trade risked an endless amount of capital for a measly upside of $2,000. Your brokerage account would have almost certainly sent you a risk alert or a margin call before you were able to lose this much (likely requiring $50k in liquidity), but this exemplifies the outsized risks involved in selling an uncovered call option.

Now let's say you did own the necessary underlying shares when you sold the 1-year call on GOOGL (covered call). The trade would have yielded you the initial $2,000 credit, and you would have been making money on the underlying shares all the way up to $2,500. The transaction would have returned you ($2,500 - $1,450) x 100 + $2,000= $107,000 or a 74% profit.

Since you owned the underlying shares, you still wanted the stock to go up, and the predetermined strike price you initially sold the call at was merely your exit price.

How To Take Advantage 

Market selloffs are the best times to execute a covered call strategy because the surge in volatility causes the premium of these options to spike (seen as an increase in theta on an absolute value basis). The higher the implied volatility (IV), the more uncertain the stock's future price is, which is reflected as an increase in the option's value. This allows you to capture a larger credit on the calls you would like to write.

Remember only to sell calls that are tolerably out-of-the-money (above the market price of underlying shares) to ensure that you capture both the option credit and any potential upside in the share price if the stock does end up rallying.

There are a couple of crucial judgments you need to make when trading covered calls: what price you are willing to sell your stock at and whether you believe the market's volatility?

When I write a long duration covered calls (6 to 18 months till exp.) I typically choose a strike price that I have predetermined to be my price target (where I am willing to let go of the stock). If I'm selling a short-term covered call (1 week to 3 months till exp.) I am taking advantage of sustained volatility and will continue to roll these calls over each time the prior one expires (like a high-yielding fixed-income security).

Now, if I believe that volatility for a specific stock has peaked, I would be looking to sell calls around 3 to 6 months out to lock in the IV premium on a more expensive contract (much further out than that, and the IV won't be as impacted by the current market environment).

The Strategy

If you are looking to add equities to your portfolio with a size of 100 shares or more, it may be prudent to sell a call option simultaneously. I am focused on growth-oriented tech because of this sector's recent valuation compressing price action and significant levels of theta driving volatility.

Stocks I'm looking to add are positioned for the next generation economy like AI-power customer service automator Twilio (TWLO - Free Report) , best-in-class cybersecurity platform CrowdStrike (CRWD - Free Report) , and real-time machine data management powerhouse Splunk (SPLK - Free Report) . These stocks have long-term winners but are experiencing significant short-term uncertainty.

These nascent tech enterprises hold a leadership position in their niche operating segments and have a compelling growth narrative that shouldn't be ignored. They will undoubtedly play a vital role in the commencing 4th Industrial Revolution, which is already rapidly digitalizing our global economy.

Take a look at your portfolio and examine stocks where you hold a 100+ share position (1 call per 100 share block), with the highest IVs to capture the most theta. This call selling tactic will not make you rich quick, but it is a savvy way to capture returns in a down-trending market.

Final Thoughts

Make sure you are willing to exit these covered call positions at the strike price you chose. I am looking to sell Oct 15 expiring calls, as I don't believe we will get a material market turnaround until Q3 earnings from big tech begin hitting the wire at the end of the month, which will allow me to roll these calls over.

Keep in mind that the shorter the duration and further out-of-the-money your option's strike is, the lower the premium will be. When playing with options, I find it's always better to be safe than sorry. I remain bullish for Q4 and am buying this stock market dip.

Good luck!

Dan

Equity Strategist & Editor of The Headline Trader Portfolio


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