Premium of Selling in-The-Money Calls
It`s All About Monthly Cash Flow
By Saghir Aslam
Rawalpindi, Pakistan
(The following information is provided solely to educate the Muslim community about investing and financial planning. It is hoped that the Ummah will benefit from this effort through greater financial empowerment, enabling the community to live with dignity and fulfill their moral obligations towards charitable activities)
(Continued from last week)
In that last sentence is a hidden secret. I used the expression “all of the stocks.” Very seldom will all of your stocks rise. A decision you need to make is: how big of a rate of return do you want to go for? Do I want a bigger rate of return, or do I want more certainty? Oddly enough, the answer to those questions is also found in the same overriding question I keep reminding you to ask yourself: “Do I want to sell this stock?”
COVERED CALL STRATEGY
Whenever the stock market breaks a major trend, many investors are caught off guard and immediately react by freezing their activity. This presents a problem because if you stop actively trading, you can`t make any money. To avoid this situation, you need to stay flexible and plan ahead. Look for early warning signs of a reversal and think about how you can change your strategy to profit from the coming market.
Judging from market indicators such as the Russell 2000 Index, it may be time to make adjustments to your call writing strategy. Established in 1984, the Russell 2000 Index is comprised of the 2,000 smallest companies in the Russell 3000 Index. The analysts on CNBC frequently use it as the yardstick to measure the progress of small cap stocks. I use the index in my trading to determine how price is trending among covered call-writing stocks. My analysis of the Russell 2000 is similar to our practice of following sector trends seen covered candidates in the trading range of $5 to $30. When the Russell 2000 Index trends up, about 70% of these candidates move with it. As the index trends down, about 90% move with the downtrend.
How can I adjust existing covered call strategy to adequately handle a downtrend? It`s possible to continue selling covered calls out-of-the-money, but be prepared to buy the calls back and sell the stock should the price of the stock move lower with the market. This will require close monitoring and will have higher commission costs. In addition, your returns may be lower because option premiums don`t always keep pace with the reduction in stock value as price moves down.
As an alternative, you might want to consider writing in-the-money calls, which have the advantage of larger premium. These premiums may not only meet your investment goals of 10% to 20% monthly returns but also offset the deterioration in your stock value. Write the calls on stock you think might move higher on upward correction and then lower with the general market trend. There is less upside profit, but considerably more downside protection. This strategy provides a hedge and helps protect the value of your stocks.
If the stock price remains below the $15 strike price at expiration, I have the opportunity to sell calls for another month. I suggest rolling out to the next month when the value of your stock trends downward. Essentially, this means selling more option premium month after month, reducing your cost basis all the while as the price moves lower. This is excellent, as it will keep you in the market and save you on commission costs you would otherwise have by simply buying the peaks. Commissions on stock trades are generally higher than on options trades.
I usually think of covered call writing as a bullish strategy. However, with a little foresight and strategy.
(To be continued)
(Saghir A. Aslam only explains strategies and formulas that he has been using. He is merely providing information, and NO ADVICE is given. Mr Aslam does not endorse or recommend any broker, brokerage firm, or any investment at all, nor does he suggest that anyone will earn a profit when or if they purchase stocks, bonds or any other investments. All stocks or investment vehicles mentioned are for illustrative purposes only. Mr Aslam is not an attorney, accountant, real estate broker, stockbroker, investment advisor, or certified financial planner. Mr Aslam does not have anything for sale.)
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