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Covered Call Trading - Urgent Warning

By Chris Ebert

The S&P 500 and other stock market indices are making new record highs. Rallies in recent months - years, actually - have been strong and long lasting, with pullbacks brief and barely significant enough to reach the broadest definition of a market correction. In short, the stock market life is good. But the life of the Covered Call trader is actually not so good.

The stock-buying frenzy of the current Bull market has once again reached a level reminiscent of "lottery fever", in which a huge lottery jackpot induces euphoric spending by folks seeking a share of the winnings. Just as such a jackpot lures non-lottery-playing people into buying a ticket, stock market lottery fever lures money from the sidelines from those who normally would shy away from buying stocks.

An increase in demand for stocks tends to result in an increase in stock prices; and the increase in price actually creates further demand. It is a vicious cycle, not unlike the process that increases a lottery jackpot, and it's known here as Bull Market Stage 1. Stage 1 would seem to offer a great opportunity to sell Covered Call options, since Covered Call trading returns profits when stock prices rise, and prices rarely rise as consistently as they do during Stage 1. However, the current Covered Call trading environment may not be as good as it initially appears.

Click on chart to enlarge

*All strategies involve at-the-money options opened 4 months (112 days) prior to this week's expiration using an ETF that closely tracks the performance of the S&P 500, such as the SPDR S&P 500 ETF Trust (NYSEARCA:SPY)

You are here - Bull Market Stage 1 - the Lottery Fever Stage.

On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending May 31, 2014, this is how the trades performed:

  • Covered Call trading is currently profitable (A+). This week's profit was +3.4%.
  • Long Call trading is currently profitable (B+). This week's profit was +3.7%.
  • Long Straddle trading is currently profitable (C+). This week's profit was +0.3%.

Using the chart above, it can be seen that the combination, A+ B+ C+, occurs whenever the stock market environment is at Bull Market Stage 1. For a description of Stage 1, as well as a comparison to all of the other stages, see the chart below (click to enlarge):

Hidden Covered Call Danger during Bull Market Stage 1

Bull Market Stage 1 is the most bullish of all of the Options Market Stages (click the photo to the left for a complete description of all of the Options Market Stages). The current roaring Bull market might seem like the perfect environment for selling Covered Calls. But, there are some important risks to consider.

Click on chart to enlarge

A Covered Call is a trade in which 100 shares of stock are purchased at the same time that 1 standard Call option is sold. Buy 100 shares, sell 1 Call, and that's all there is to a Covered Call. The trader gets to keep the amount collected on the sale of the Call, known as the "premium", no matter what happens. The premium on a single Call option can be any amount, but generally ranges from a few hundred dollars to several thousand dollars, all of which the seller of that option is free to retain.

Risk #1 - Falling Stock Prices

While collecting hundreds, perhaps thousands of dollars on a single Covered Call is almost certain to seem appealing, every trader must understand the risks involved. Probably the most obvious risk is that the trader owns 100 shares of stock, which, like all stocks, can go down in price. What that means for a Covered Call trader is that there is a risk of loss, possibly a substantial loss, if the stock price falls by a greater amount than the premium collected on the sale of the Call option.

What good does it do to retain the $200 premium collected on the sale of a Covered Call option if the stock price falls and results in a $500 loss? None - because the net trade amounts to a $300 loss.

Due to the risk posed by falling stock prices, Covered Calls are best left to Bull markets. Since the current stock market environment is about as bullish as it gets, it might seem like now would be a great time to trade them.

When the S&P 500 enters Stage 1, it tends to climb until it reaches its maximum limit, depicted by the green line in the chart below. Of course, there is always a possibility that unexpectedly poor economic news will pull the S&P down before it reaches the green line, but the tendency is for it to seek out that limit, as was the case when Lottery Fever infected the stock market this past November, December and January. That means the tendency is toward higher stock prices in coming weeks, which would result in profits for Covered Call traders. However, profits, as welcome as they may be, do not tell the whole story.

Risk #2 - Rising Stock Prices

A Covered Call trader does not just collect a premium out of thin air. The seller of a Covered Call must agree to give all of the profits from the stock, if there are any, to the buyer of the Call option. That's what the Covered Call trader is getting paid to do - to give all of the profits above a set stock price, known as the "strike price", to the buyer of the Call option.

So, what's so bad about giving away all of the profits on a stock if it means collecting a nice option premium? After all, profit is profit, right? Well… there's profit, and then there is PROFIT! What good does it do to collect a $200 Call option premium only to give away what would have been a $500 profit on the stock. Sure, it's still a $200 profit. But it would have been a $500 profit had the stock been purchased without the sale of the Covered Call.

Raging Bull markets, like those that tend to accompany Bull Market Stage 1, often result in huge increases in stock prices. That means a seller of Covered Calls risks giving up considerable gains on stocks when Bull Market Stage 1 is underway, as it is currently.

Risk #3 - Low Premiums

Not only does a Covered Call seller potentially risk missing out on substantial gains in a stock price, but the premium collected is generally quite low when Bull Market Stage 1 is underway. The Volatility Index, known as the VIX, is perhaps best known as a measure of fear among stock traders. But, while often used as a fear gauge, it is actually a measurement of option premiums. With the VIX currently near 11, it is near record lows, indicating that option premiums are near record lows as well.

Low premiums present a quandary for Covered Call traders. If a trader sells a Covered Call with a strike price that is equal or nearly equal to the share price of the stock, known as an "at-the-money" or "ATM" strike price, such an option will require giving 100% of the profits on the stock to the buyer of the Call option. In a strong Bull market, that could entail giving away huge gains if the stock rallies. To make matters worse, when the VIX is as low as it is today, that means giving up 100% of the profit while collecting a relatively small premium.

Covered Call traders are under no obligation to use at-the-money strike prices. By using a higher strike price, it is possible to keep a portion of the profits on the stock, since the Call seller is only obligated to relinquish those profits that are in excess of the strike price of the option. Such options are known as "out-of-the-money" or "OTM" options. The problem with selling out-of-the-money Covered Calls is that the premiums are much lower than those at at-the-money strike prices. So, while there is a potential to keep some of the profits on the stock if they occur, there is also much less premium to offset any losses in the event the stock price tumbles.

As an example, a trader might collect $2.00 per share on an at-the-money Covered Call but only $0.50 per share on one that is out-of-the-money. On a standard option contract of 100 shares, the OTM Covered Call seller would collect only $50 - hardly worth the effort, not to mention the risk of loss if the stock price was to fall more than 50 cents per share. That's the risk accompanying the lower-than-normal option premiums that often occur during Bull Market Stage 1.

Risk #4 - Increasing Volatility

As mentioned above, option premiums are now at some of the lowest levels in decades. This is due in large part to a lack of fear in the stock market. If fear was to return, it is likely that option premiums could increase considerably. As a rough measure, premiums on at-the-money options will generally be twice as high if volatility doubles, when compared to at-the-money premiums prior to the increase in volatility.

For example: If an at-the-money Call option on $SPY had a premium of $1 when the VIX was at a level near 11, it would be expected that the premium of an at-the-money Call would be $2 if the VIX increased to 22. Double the VIX - double the premium.

Increasing volatility can present a real problem for a Covered Call trader. Implied volatility generally increases when stock prices fall. The increase in volatility can be seen as an increase in option premiums. Thus, falling stock prices tend to cause an increase in option premiums. While an increase in Put option premiums is easy to comprehend when stock prices fall, Covered Call traders cannot ignore the tendency of Call option premiums to increase as well.

Although the premium of a Call option will usually decrease when the underlying stock price declines, an increase in implied volatility can cause the decrease in premium to be much smaller than it would otherwise be. A Covered Call trader can get stuck with large losses on a stock, while experiencing little or no gain on the Call option, if that option premium is inflated by an increase in implied volatility.

When the stock market is experiencing Bull Market Stage 1, implied volatility is usually quite low, so it doesn't take much of a jolt to cause an increase. Thus, Bull Market Stage 1 poses an often hidden risk, known as "volatility risk" or "vega risk", which could potentially be detrimental to a Covered Call trader.

Some traders may opt to sidestep the vega risk of Covered Calls by selling the stock if the share price declines sharply. Selling the stock leaves the Call uncovered, or "naked", presumably to expire worthless despite a temporarily inflated premium. Naked Calls, however, present their own set of risks, namely the potential for huge losses if the stock price rallies above the strike price prior to expiration of the option.

What's a Covered Call Trader to Do?

The basic advice for Covered Calls is to avoid them during a Bear market. But, it turns out they are not really a great choice during a raging Bull market either. The option premiums during Bull Market Stage 1 are often too low to justify the risk, not only the risk of loss on the stock, but also the very real potential of missed profits when the Call option is assigned.

Since option premiums are often at their lowest during Bull Market Stage 1, it is worth considering that buying Calls may be preferable to selling Covered Calls. In fact, Long Call profits will exceed Covered Call profits in almost any large rally, while Long Call losses will be minor compared to Covered Call losses if an unexpected sell-off ensues. Meanwhile, Covered Calls are more suited to sideways, range-bound markets, or minor corrections, such as might accompany Stage 2, 3, or 4. The chart above shows the past few years of historical performance of buying Calls, known as "Long Calls" versus that of Covered Calls using an Exchange Traded Fund or "ETF" that tracks the S&P 500 index.

It should be noted that Long Calls are currently returning profits that are nearly equal to those of Covered Calls at the same strike price and expiration. However, the risk of loss on Long Calls is very limited, while the risk of Covered Calls is essentially limitless. The Long Call buyer can never lose more than the initial premium paid, while the Covered Call seller can lose the entire amount used to purchase the stock if the stock price was to fall to zero. Therefore, it may be preferable to buy Long Calls, when weighing their potential reward against their risks, especially during Bill Market Stage 1. An added bonus for Long Calls is that their vega risk is the exact opposite of Covered Calls, such that Long Call premiums tend to be inflated when the trade moves unfavorably, that is, when stock prices fall, which often mitigates potential losses.

While option premiums are as low as they are, now is also a good time to consider buying Put options as protection for stocks that are already owned, known as "Protective Puts" or as a simultaneous purchase along with a stock purchase, known as a "Married Put". As with Long Calls, Married Puts and Protective Puts each harbor a vega component that can mitigate losses when the stock price falls.

The 10-uear historical performance of Long Calls and Married Puts on the S&P 500 can be seen in detail on the chart of the Long Call/Married Put Index (#LCMPI) which follows.

Weekly 3-Step Options Analysis:

On the chart of "Stocks and Options at a Glance", option strategies are broken down into 3 basic categories: A, B and C. Following is a detailed 3-step analysis of the performance of each of those categories.

STEP 1: Are the Bulls in Control of the Market?

The performance of Covered Calls and Naked Puts (Category A+ trades) reveals whether the Bulls are in control. The Covered Call/Naked Put Index (#CCNPI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames. Most important is the profitability of these trades opened 112 days prior to expiration.

Covered Call trading did not experience a single loss in 2013, and the streak endures so far in 2014, continuing a streak of nearly lossless trading extending all the way back to late 2011. That means the Bulls have been in control since late 2011 and remain in control here in 2014. As long as the S&P remains above 1784 over the upcoming week, Covered Call trading (and Naked Put trading) will remain profitable, indicating that the Bulls retain control of the longer-term trend. The reasoning goes as follows:

• "If I can sell an at-the-money Covered Call or a Naked Put and make a profit, then prices have either been going up, or have not fallen significantly." Either way, it's a Bull market.

• "If I can't collect enough of a premium on a Covered Call or Naked Put to earn a profit, it means prices are falling too fast. If implied volatility increases, as measured by indicators such as the VIX, the premiums I collect will increase as well. If the higher premiums are insufficient to offset my losses, the Bulls have lost control." It's a Bear market.

• "If stock prices have been falling long enough to have caused extremely high implied volatility, as measured by indicators such as the VIX, and I can collect enough of a premium on a Covered Call or Naked Put to earn a profit even when stock prices fall drastically, the Bears have lost control." It's probably very near the end of a Bear market.

STEP 2: How Strong are the Bulls?

The performance of Long Calls and Married Puts (Category B+ trades) reveals whether bullish traders' confidence is strong or weak. The Long Call/Married Put Index (#LCMPI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames. Most important is the profitability of these trades opened 112 days prior to expiration.

Long Call trading became unprofitable this past March, Those losses intensified during April and early May before reverting back to profits in recent weeks. Losses for Long Calls are a sign of weakness for a Bull market. Such weakness can be dangerous because it lowers the perceived reward potential for stock owners, which makes stocks less attractive, in turn lowering the price stock sellers are able to obtain from buyers.

Failure of the S&P to close next week above 1894 would be a sign of renewed weakness; and weakness always has the potential of putting downward pressure on stock prices. If the S&P fails to close the upcoming week above 1894, Long Calls (and Married Puts) will fail to profit, suggesting the Bulls have lost confidence and strength. The reasoning goes as follows:

• "If I can pay the premium on an at-the-money Long Call or a Married Put and still manage to earn a profit, then prices have been going up - and going up quickly." The Bulls are not just in control, they are also showing their strength.

• "If I pay the premium on a Long Call or a Married Put and fail to earn a profit, then prices have either gone down, or have not risen significantly." Either way, if the Bulls are in control they are not showing their strength.

STEP 3: Have the Bulls or Bears Overstepped their Authority?

The performance of Long Straddles and Strangles (Category C+ trades) reveals whether traders feel the market is normal, has come too far and needs to correct, or has not moved far enough and needs to break out of its current range. The Long Straddle/Strangle Index (#LSSI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames. Most important is the profitability of these trades opened 112 days prior to expiration.

The LSSI currently stands at +0.3%, which is normal, and indicative of a market that is neither in imminent need of correction nor in need of a major breakout from the trading range of the last few months. Positive values for the LSSI represent profits for Long Straddle option trades. Profits represent an unusual condition for Long Straddle trading, one of three unusual conditions that warrant attention.

The 3 unusual conditions for a Long Straddle or Long Strangle trade are:

  • Any profit
  • Excessive profit (>4% per 4 months)
  • Excessive loss (>6% per 4 months)

The reasoning goes as follows:

• "If I can pay the premium, not just on an at-the-money Call, but also on an at-the-money Put and still manage to earn a profit, then prices have not just been moving quickly, but at a rate that is surprisingly fast." Profits warrant concern that a Bull market may be becoming over-bought or a Bear market may be becoming over-sold, but generally profits of less than 4% do not indicate an immediate threat of a correction.

• "If I can pay both premiums and earn a profit of more than 4%, then the pace of the trend has been ridiculous and unsustainable." No matter how much strength the Bulls or Bears have, they have pushed the market too far, too fast, and it needs to correct, at least temporarily.

• "If I pay both premiums and suffer a loss of more than 6%, then the market has become remarkably trendless and range bound." The stalemate between the Bulls and Bears has gone on far too long, and the market needs to break out of its current price range, either to a higher range or a lower one.

*Option position returns are extrapolated from historical data deemed reliable, but which cannot be guaranteed accurate. Not all strike prices and expiration dates may be available for trading, so actual returns may differ slightly from those calculated above.

The preceding is a post by Christopher Ebert, co-author of the popular option trading book "Show Me Your Options!" He 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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