How Create Yield in Today’s Choppy Market
Trading Covered Calls for Increased Income
A Facebook Covered Call Strategy
For the past couple of months, the S&P 500 has traded in an incredibly tight range. One day the market looks ready to break to all-time highs, and the next day it seems to be on the precipice of disaster. Yet, at the end of the day/week/month, the S&P 500 is back within a range of plus or minus a couple of percent of 1850, which is essentially where we started the year.
This choppy action makes for a difficult environment for investors and traders to make money in.
On the one hand, the growth and small-cap stocks are seemingly breaking down and several investing titans are voicing concerns. Hedge-fund manager David Einhorn recently said, “There is a clear consensus that we are witnessing our second tech bubble in 15 years.” Then last week, fellow hedge fund manager David Tepper, who has been extremely bullish for quite some time, said, “I am nervous. I think it’s nervous time.” Then he went on to say, “I’m not saying go short. But don’t be super long either.”
Yet even as these hedge fund legends make cautious statements, and growth and small-cap stocks break down, the big caps remain within 1% of all-time highs. This is a confusing situation for everyone.
In this type of choppy environment, one of the toughest things for a trader to avoid is overtrading. Often boredom sets in, and the need to trade, to create some “action” becomes overwhelming … but that’s the worst thing you can do. As the old Wall Street saying goes, “Do nothing, absolutely nothing, until there is something to do.”
So how can we make money in a market that’s choppy and is seemingly going nowhere? I like to create yield by using Covered Call (or Buy-Write) strategies.
A covered call is an options strategy whereby an investor holds a long position in a stock, and sells a call option on the same stock in an attempt to generate increased income from that stock. This strategy should be used when an investor has a neutral view on the stock.
Let’s take a look at a covered call trade we used recently in Cabot Options Trader and how the strategy played out.
In early March, we initiated a covered call strategy in Penn Virginia (PVA). We bought PVA stock at 15.20 and sold the March 15 strike call for $0.75. By selling this call against our long stock position, we were giving the owner of the call the right to buy our stock from us if PVA was trading above 15 on the call’s expiration.
On March 22, the day the call expired, PVA was trading over 15. Therefore, the owner of the call that we sold exercised his right to buy the stock from us. We had to sell the stock at 15, a $0.20 per share loss. However, because the loss is more than made up by the premium of $0.75 per share that we collected when we sold our call, we ended up netting a profit of 3.8% in just a couple of weeks’ time.
And where is PVA trading today? Virtually unchanged at 15.50.
Now let’s take a look at how a covered call strategy would have worked in Facebook (FB) in the past several months.
Facebook has traded like most growth stocks in recent months-choppy and sloppy. Every time it looked like the stock was ready to bounce back, it failed. Every time it looked like it was going to fall to new lows, it bounced back.
So how could a post-earnings covered call strategy have worked in Facebook?
Facebook reported earnings on April 23, and in the following days the stock fell from 63 to 58. Theoretically, we could have initiated a covered call strategy on FB by purchasing FB stock at 58 and selling the May 60 call for $1.
If FB stayed below 60 on May expiration (three weeks later), we would continue to own FB stock and collect a premium of one dollar, or $100 per call we sold.
In fact, Facebook closed at 58.02 when the option expired, so the call expired worthless. Thus, we would have collected $100 or a yield of 1.75% in three weeks.
And when our May call expired, we could then go out and sell the June 60 call for $2.
If FB were to close at or below 60 on the June expiration, we’d collect another $200 per covered call, or another 3.57% yield, and would still have our stock position.
If FB were to close above 60, we’d lose our stock position as the call buyer would exercise his right to buy the stock from us for $60 per share, but we would make at least $200 on the stock appreciation and another $200 on our call-a yield of 7.14%!
I know that’s a lot of numbers and decimals, but really, the strategy isn’t all that complicated-you’re simply selling a call against a stock you own.
As these examples show, there are ways to make money in a choppy market. While 3.8% yields like those we made in PVA may not sound like much, if you can repeat the process every month, you’ll be sitting on a pretty outstanding return at year-end … especially in a choppy market.
Your guide to successful options trading,
Chief Analyst, Cabot Options Trader/Cabot Options Trader Pro
P.S. Our tactical trading systems hands individual investors double- and triple-digit profits in days or weeks, not months or years. Use the trading strategies that hedge fund managers use to make money, even in this crazy market. Puts, calls and covered calls let you use leverage to profit from movements in stock price-up or down-and Cabot Options Trader shows you just how to do it.