Fading The Rally With Covered Calls: Earn Income, Some Downside Protection

by: Parsimony Investment Research

As euphoria takes over the market due speculation of an agreement to contain Europe’s debt crisis and further Federal Reserve stimulus, we suggest that investors take a more cautious approach to their portfolio and sell calls against existing positions. Selling out-of-the-money calls on existing positions will provide investors with income and some limited downside protection as markets inevitably turn their focus on the underlying problems in the economy and global financial markets.

Options prices are based on the Black-Scholes options pricing model. The Black-Scholes model is a complex mathematical formula based on the following inputs: underlying stock price, strike price, time to expiration, risk-free interest rate, and volatility. As markets have remained quite volatile since August, the implied volatility of many equity options are at elevated levels. The higher the implied volatility the higher the option premium.

We have been over-writing out-of-the-money call options on our existing equity portfolio as we think the current rally will unlikely last into 2012. Due to persistently high unemployment and a focus on austerity, we think that 2012 could be a very challenging environment for equities.

Tactical Strategy

Sell out-of-the-money calls on existing positions with a strike price of approximately 15%-20% above the current price. In the case of SLV we sold out-of-the-money calls at significantly higher prices due to our underlying bullishness of the metal. Outlined below are some our holdings which we sold covered calls against (click to enlarge image):

Covered Call Basics

The covered call is a strategy in which an investor writes a call option contract (for an equivalent number of shares) on a stock that the investor already owns. This strategy is the most basic and most widely used strategy combining the flexibility of listed options with stock ownership.

Though the covered call can be utilized in any market condition, it is most often employed when the investor desires to either generate additional income (over dividends) from shares of the underlying stock, and/or provide a limited amount of protection against a decline in underlying stock value.

While this strategy can offer limited protection from a decline in price of the underlying stock and limited profit participation with an increase in stock price, it generates income because the investor keeps the premium received from writing the call.

At the same time, the investor can appreciate all benefits of underlying stock ownership, such as dividends and voting rights, unless he is assigned an exercise notice on the written call and is obligated to sell his shares. The covered call is widely regarded as a conservative strategy because it decreases the risk of stock ownership.

Disclosure: I am long MO, AGNC, NLY, EEM, SLV, JNJ, SPY.