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Stock Option Investing on the Dips with Bollinger Bands and Covered Calls

|Includes: Exxon Mobil Corporation (XOM)
Bollinger Bands
The Bollinger Band concept is named after John Bollinger who developed the concept.  Bollinger Bands consist of three bands, one of which is a simple moving average [SMA].  A typical value used for calculating the SMA is 20.

The other two bands consist of a lower and an upper band located below and above the SMA band, respectively.  The distance or difference between the upper band and the SMA band and between the lower band and the SMA band is typically a multiple of the standard deviation below and above the SMA band, respectively.  A common multiple used for the standard deviation is 2.

A graph demonstrating the concept of Bollinger Bands is shown below for the large oil company Exxon Mobil (NYSE:XOM).

The line illustrated in blue in the chart is the stock price for XOM over the previous year.  The line illustrated in purple is the twenty-day SMA for Exxon's stock price.  The upper and lower Bollinger Bands are illustrated in black.

Lower Bollinger Band
One interesting characteristic to note is that almost each time the price of Exxon's stock fell below or was near the lower Bollinger Band, the price of the stock would very soon thereafter recover or increase in price.  In most cases, if the price of the stock dropped below the lower Bollinger Band, it did so only very briefly as it did in the month of April.

Upper Bollinger Band
Another interesting phenomena to observe, is that almost each time the price of the stock neared the lower Bollinger Band, the stock would reverse course and drop in price.

We will investigate investing in XOM starting on 4/15/2009 and exiting on 10/12/2009.  The price of XOM closed at \$68.14 on 4/15/2009 and at \$70.13 on 10/12/2009.  Simply purchasing XOM on 4/15/2009 and selling on 10/12/2009 would have netted a profit of \$1.99 for a 2.9% return.

Another approach to investing would be to purchase XOM when it's stock price dips and sell the stock when it's price has peaked.  We will use Bollinger Band's to determine the peaks and valleys.  When the price of the stock is at or less than the 20th percentile of the distance between the upper and lower Bollinger Bands, we will purchase the stock.  Additionally, when the price for the stock is at the 80th percentile or greater of the distance between the bands, we will sell the stock.  The buy and sell points as represented by this strategy are shown below in the table:

The buy-on-dips / sell-on-peaks Bollinger Band method return of 12.9% was a gain of 10% over the simple buy-and-hold strategy's return of 2.9%.

The graph below illustrates the entry and exit positions for the strategy:

Bollinger Band + Covered Call
We will now investigate adding a covered call strategy to the buy-on-dips / sell-on-peaks Bollinger Band strategy.  Instead of simply purchasing a long stock when entering a position, we will also sell an out-of-the-money call option against the stock to enter a covered call position.  An out of the money call option is one in which the strike price of the call option is greater than the price of the stock.  An out-of-the-money call option has the advantage of generating income from the time value of the call option and also from an increase in appreciation in the price of the stock.  Using PowerOptions (poweropt.com) historical stock options tools, we were able to find the following call options for entering a covered call position as shown in the table below:

For the covered call entered on 6/23/2009, the call option was exited on 7/17/2009 which was the date the call options expired.  In each case, except one, the covered call strategy added additional return over the buy-on-dips / sell-on-peaks Bollinger Band strategy.  The position entered on 8/11/2009 experienced a combined return of 3.1% versus the straight buy-on-dips / sell-on-peaks Bollinger Band return of 4.7%.

Results
The results of the three strategies are compared in the table below:

Combining the covered call strategy with the buy-on-dips and sell-on-peaks Bollinger Band strategy added an additional 1.5% of profit.  Additionally, the covered call strategy provides downside protection which neither the buy-and-hold nor the buy-on-dips/sell-on-peaks Bollinger Band strategies provided.  In each covered call position, the price of XOM could have fallen several percentage points and the positions would have experienced a profit.

Combining the covered call strategy with the buy-on-dips / sell-on peaks Bollinger Band strategy is best employed on very large companies which are stuck in a trading range, as was the case with Exxon Mobil.

Disclosure: No positions in Exxon Mobil - XOM.