By Chris Ebert
Covered Call trading is often touted as a great way to earn income from stocks that a trader already owns. The trader sells a Call option on the owned stock and collects a fee known as the option premium.
The problem with selling a Covered Call option is that it limits the profits on the stock if the stock price rises. When the stock price rises above a certain price, known as the option strike price, all profits beyond that point are lost and go to the buyer of the option.
Option trading can seem daunting to those who have never done it. But Covered Call trading is relatively simple. A trader who owns 100 shares of stock can sell what is known as a Call option, which essentially gives up the right to profit on that stock. In return, the seller collects capital in the form of an option premium. Most brokers can walk a trader through the process; many traders qualify with a simple request to their broker to trade Covered Calls.
Selling Covered Calls is generally not a good idea in a strong rally, because the buyer of the Call option is reaping huge profits while the seller is getting just a small premium. Exacerbating the situation is that when a strong rally is in progress, implied volatility is low – and implied volatility is a measure of option premiums. Quite simply, when there is a rally in stock prices, option premiums tend to decrease, so that sellers of Covered Calls are collecting very small premiums yet giving up huge profits to the buyers of the Calls.
One way of gauging a good time to sell Covered Call options is to look at the S&P 500 Temperature. When it is above 200 it means the stock market is hot; but a Temperature above 250 often indicates a rally is reaching its limit. There are two important implications:
- Because the market is so hot, chances of a major decline in stock prices are generally lower
- Because the market may be nearing a top, chances of giving up huge gains in a major rally are also lower
It’s not a good practice to sell Covered Calls and give up potential huge gains during an explosive rally in stock prices. It’s also quite risky to sell Covered Calls when stock prices are falling quickly.
That can make an S&P 500 Temperature around 250 an optimal time to sell a Covered Call. Despite the fact that premiums tend to be very low when the Temperature is that high, the chance of a major pullback in stock prices tends to be low when the market is that overheated, while the chance of a runaway rally is also low, again because of the overheating. An overheated condition may cause traders to take profits during rallies and thus limit the uptrend; it also causes traders to buy stocks on dips, which tends to limit any pullbacks in prices.
Just as an example, when the $VIX is 20 during an ordinary market, overall option premiums would tend to be double what they would be during a rally in the S&P 500 in which the $VIX fell to 10. A Covered Call seller would likely collect half the Covered Call option premium during an S&P rally as under normal market conditions. Individual stocks might have different results, but generally option premiums would be half.
So, when is the best time to sell Covered Call options? A trader certainly doesn’t want to sell a Covered Call for a meager premium and give up huge gains to the buyer, nor does he want to sell one for a large premium during a period of high volatility and collect a large premium only to suffer a huge loss on the stock. That would seem to imply that selling Covered Calls near a top in the market would be the best choice; and over the past 20 years tops have tended to occur when the S&P Temperature was near 250. It’s just a tendency though, not a guarantee.
Nobody can call a top, though many traders continue to attempt to call a top. But there are indicators that signal a top is near; and the S&P 500 Temperature is one of those indicators that traders of Covered Calls may find helpful.
The preceding is a post by Christopher Ebert, co-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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