By Chris Ebert

Covered Call trading is often one of the first types of trading that new options traders encounter, and for good reason. Covered Calls in most instances carry no more risk of loss than outright stock ownership; thus anyone who has traded stocks can usually handle these options contracts without taking on any more risk than they otherwise would in their stock trades.

But, Covered Call options, just as stock ownership, are not without risk. Covered Call sellers can and do lose considerable amounts of capital at times, particularly when stock prices decline. In addition, the seller of a Covered Call gives up all or part of the profits on the selected stock, and thus can lose out on tremendous gains when stocks rally.

The quandary for the Covered Call trader is that it involves considerable risk – nearly the same as buying shares of stock – but limits the possibility of any immense reward. Certainly the trader receives compensation for this in the form of an option premium; but that premium can either be too small to offset the risk of owning the stock (if the stock price falls sharply) or too small to offset the reward that otherwise would have been obtained (if the stock rallies).

That makes Covered Call trading ideal only in a market in which stock prices move sideways. The seller of the Covered Call in a sideways market neither suffers losses from steep declines in stock prices, nor gives up what might have been potential gains from price increases. Though there have been up days and down days, stock prices have been going mostly sideways for quite some time now. That means 2016 has been a banner year for Covered Call trading.

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While there are many varied methods for trading Covered Calls, given the myriad options available, the highest volume of trades tend to be executed near what is known as an at-the-money (ATM) strike price. Of those trades many tend to be executed at what is known as a near-month expiration date, usually within a few months after the contract is initiated. Of the countless options contracts traded each day, perhaps none are more representative of the overall U.S. stock market than those on one of the most heavily traded Exchange Traded Funds (ETFs) known as “the spy”, aptly named from its stock-ticker symbol $SPY.

The most commonly traded options on $SPY – those that have at-the-money strike prices and near-month expirations – can act as a barometer for the stock market as a whole.

When this specific type Covered Call trading is profitable (when the S&P 500 is anywhere above the red zone on the chart) it represents a stock market in which there are no huge declines. But when the S&P fails to enter the green zone on the chart it also means the magnitude of any rallies have not been surprisingly large.

Thus, when the S&P remains in the blue zone, as it has for several months now, it can be a Covered Call trader’s paradise. The trader neither loses capital from owning the stock (as he likely would if the S&P entered the red zone) but gives up very little in the way of potential profit on the stock (as he would if the S&P entered the green zone). Furthermore, the Covered Call trader has not had to deal with the uneasiness that often enters the market when the S&P enters the yellow or orange zones.

Sell-offs that bring the S&P into the yellow or orange always make a Covered Call trader think that the red zone could be next – and that would mean a loss. So sellers of Covered Calls could be tempted to close their positions early when the S&P goes into the yellow or orange, to avoid experiencing a potential loss that would occur in the red zone. But that hasn’t happened much in the past six months. As long as the S&P remains in the blue zone, a Covered Call trader is likely to let the trade run until expiration, thus reaping an eventual profit by pocketing the option premium.

For most of 2016 Covered Call trading has been ideal on broad based ETF’s such as $SPY. It’s been a set-it-and-forget-it type of trade. That’s not always the case; so newer Covered Call traders need to be aware that the environment for these trades is rarely this friendly, and it will eventually come to an end. Stock traders also need to be aware that a Covered Call trader’s paradise, being abnormal, is indicative of an abnormally complacent stock market.

The implication is that stock prices will soon break out of the range they seem to have been confined in for the past six months or so. There are only two reasons stock prices move sideways for such a long period:

  1. The market has had a lack of news to act as a catalyst that would move stock prices
  2. The market has reached a sort of equilibrium that makes it temporarily immune to any news catalyst

Neither of those conditions is sustainable for any long period of time. When the current paradise for Covered Call trading finally does come to an end, it will also come with a new environment for stock traders.

 

 

The preceding is a post by Christopher Ebert, author of the popular option trading book “Show Me Your Options!” Chris uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. Questions about constructing a specific option trade, or option trading in general, may be entered in the comment section below, or emailed to OptionScientist@zentrader.ca

 

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