This Income Strategy Lets You Have The Best Of Both Worlds
We’ve spent some time recently covering the tremendous benefits of the covered call strategy. This options strategy allows us to boost the amount of income we receive from our portfolio while also protecting from losses if they trade moderately lower.
However, the strategy has one primary drawback. If the underlying stock that we own moves dramatically higher, our gains are capped. This is because we must sell our stock at a specified price (the strike price) should it close above this price when the calls expire.
Generally, we should be happy to take this trade-off. In most cases, a high-probability opportunity to make a solid total return is preferable to a low-probability chance to make a much larger gain. That’s why this strategy should be appealing to a stable, systematic investor rather than a long-shot gambler.
There are times, however, when the long-term opportunity for an investment is just too good to completely pass up. Does this mean we should avoid selling covered calls on the position? Not necessarily…
Creating Income While Still ‘Letting Some Ride’
When presented with a situation like this, a conservative-minded investor could set up a “fractional covered call approach”.
This scenario is particularly suited for high-growth opportunities. It’s basically a hybrid that involves buying and holding a growth opportunity for long-term investment gains. You then sell a smaller number of covered calls against the position. This helps maintain a certain amount of reliable income in the account.
For example, you might buy 1,000 shares of a particular stock. Instead of selling 10 call contracts (remember, each call contract represents 100 shares of stock), you sell a smaller number of contracts. If you feel strongly about the growth opportunity, you might sell only 3 calls. Or if your research showed a more moderate growth opportunity, you might sell 7 contracts and leave 300 shares unhedged.
It’s OK if you’re not trading 1,000 shares at a time in your individual portfolio. You can take the same approach by trading 200 or 400 shares and then selling only one or two call contracts against your position.
Balancing Income and Growth
The key concept to remember when setting up a fractional covered call trade is the balance between reliable income and speculative growth.
Covered call trades are by nature more reliable. Philosophically, we are giving up the potential for large profits in exchange for a more reliable short-term profit. Now, this doesn’t mean that we can’t enjoy a healthy rate of return. But it does mean that if a stock rallies 50% over a few weeks, we will miss a significant part of the move.
On the other end of the continuum, the typical buy-and-hold strategy relies exclusively on price movement to generate profits. If the stock moves higher, the buy-and-hold investor makes money. If the stock trades lower, the buy-and-hold investor loses money. If the stock remains flat, no profit is made. But in reality, when stocks remain flat, the buy-and hold investor loses. That’s because he misses out on the opportunity to create profits from his capital.
Using the fractional covered call strategy gives us a chance to capture some of the benefits of both trading approaches.
From the perspective of a buy-and-hold investor, using a fractional covered call approach has the effect of diluting returns if the best-case scenario pans out.
For example, let’s say an investor owns 200 shares that rise by $5. He sold calls against half of the position, so he may only receive $500 in profit from the unhedged stock portion of the trade versus $1,000 for the buy-and-hold investor. But he will also retain the cash he received for selling the calls. That’s in addition to potential gains on the hedged portion of stock depending on the strike price of the calls sold.
But let’s say the stock price remains the same or falls moderately. The covered call trader will come out ahead of the buy-and-hold investor thanks to the income brought in.
Targeting the Right Market Environment
So when is the right time to use a fractional covered call approach? Also, how many call contracts should you sell against your position?
These are naturally subjective questions, but we can offer some guidelines. First, it is important to study the overall environment for stocks as well as the trading pattern for the stock’s sector.
During bear market periods, it makes sense to fully hedge your position. (Or even set up a ratio write where you are selling more call contracts than the number of shares that you actually own.) Covered call traders tend to benefit more from the income during bear markets because the premium price for call contracts is higher due to higher volatility.
Conversely, during bullish periods, it makes sense to sell fewer calls against your positions. That’s because the amount of income we receive from selling calls during bull markets is usually much smaller. Bull markets are typically less volatile, so options are naturally priced with less premium. Also, the opportunity for investment gains due to rising stock prices is much higher. This is an obvious statement, but it is surprising how many investors do not adjust their trading approach to match the overall environment.
The key concept here is to be aware of the overall market trend and be willing to adjust your trading approach. As in most ventures, those who pay attention to their surroundings and adapt will beat those who stick with a rigid, outdated framework.
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