Zen And The Art Of Covered Call Trading

By Chris Ebert

Option Index Summary

O.K. this is getting to be a bit ridiculous now. Over the past 65 weeks, covered call trading on the S&P 500 has returned a profit 63 times. This is not some complex, secret trade available to only the most connected insiders on Wall Street. It is a trade that almost anyone with a brokerage account can open in a matter of seconds.

The most likely reason someone would not be permitted to trade covered calls is that they have not yet asked their broker. It's really that simple – a quick phone call to the broker; or in many cases the task can be completed online. Sometimes there is a form to fill out, and all that is normally required is to check the box that says “I WANT TO TRADE COVERED CALLS.”

Covered calls are often the gateway to option trading. It is not surprising, really. There is a ton of money out there devoted entirely to option trading, and anyone who owns 100 shares or more of just about any stock can get a chunk of that money simply by asking for it. It is totally legal. It's also quick and simple; and it doesn't require any special license or degree. Covered call trading is not rocket science.

Here's how it works: A trader owns 100 shares of stock, or is willing to buy 100 shares. Let's say the stock is trading at $50 per share. The trader then chooses the price at which the stock will be sold, and this price is known as the strike price. For example, a trader might be able to choose to sell the stock at $55. In that case the strike price of the covered call would be $55.

Next the trader chooses how long to own the stock. This could be a time period from as little as a week to as much as two years. The amount of time will determine the expiration date of the covered call. For example, a trader who bought 100 shares of stock in March and wanted to own the stock for no more than a month might choose an expiration date in April.

The lower the strike price that is chosen for the covered call, the more money that will be collected when opening the trade. So although it might seem contradictory, it is sometimes possible to earn a profit on the trade even when the stock price falls. For example, if a stock is trading at $50 per share and a covered call is opened at the $55 strike price, the amount of money collected might be $2 per share. In that case, the stock price could fall to $49 and still return a profit when it is sold, because the $2 per share that was collected on the covered call is more than sufficient to offset the $1 per share loss on the stock.

Taking the above example a step further, it might be possible to open a covered call at the $50 strike price and collect $5 per share as a premium. In this case the stock price could fall to as low as $45 without resulting in a loss, because the $5 per share premium that was collected is more than sufficient to cover the loss on the stock. In this case the strike price of $50 was the same as the share price of the stock at the time the covered call was opened. When the strike price of the covered call is the same as the current stock price, the covered call is said to be “at-the-money”.

Now, back to the beginning. Over the past 65 weeks, covered call trading on the S&P 500 has returned a profit 63 times. The specific covered calls mentioned here are those that were opened on a broad-based Exchange Traded Fund (ETF) such as the “Spider” SPDR S&P 500 TRUST, also known by its ticker symbol SPY. This fund can be traded just like a stock, and it essentially provides exposure to all of the stocks in the S&P 500 index.

All of the above covered calls were opened “at-the-money”. In other words, the strike price* of the covered calls was the same as the share price of SPY at the time the trade was opened. The expiration date* for each was 4 months (112 days) away at the time each trade was opened. That's quite a track record – 63 profitable weeks out of the past 65.

Not only is the recent track record outstanding, the profits have been noteworthy as well. Each trade has returned 4%, 5%, sometimes more, in a matter of just 4 months. That is an annual rate of more than 12%. Try getting that kind of return at a bank! In fact, returns like that are fairly good anywhere; stocks, bonds, mutual funds or any other investment. And these returns did not require stock picking or market timing, just simple covered calls on SPY.

The performance of covered calls is published here each week as the Covered Call/Naked Put Index (CCNPI). The CCNPI shows the current profitability of covered call trading as well as a two-year historical record. The historical record is presented not only for clarity, but as a warning to traders: Covered call trading can and does result in significant losses from time to time. The strike price of a covered call only guarantees the sale price of the stock in the event that the stock price exceeds the strike price. If not, the covered call trader gets stuck with the stock at its current price, and that can sometimes be far lower than the purchase price.

Bear markets are often terrible times to trade covered calls. But bull markets are great; even sideways, choppy, range-bound markets work well for covered calls. That is a very important point, because as it turns out the converse is also true; if covered call trading is profitable then it is a bull market. Ever wanted a simple way to determine whether it is a bull market or a bear market? Just look at the CCNPI!

The Covered Call/Naked Put Index (CCNPI) is actually one of three option indices, each with its own insight into the stock market. Together with the Long Call/Married Put Index (LCMPI) and the Long Straddle/Strangle Index (LSSI) a complete picture of the current market conditions appears. The 3-step process is as follows:

STEP 1: Are the Bulls in control of the market?

The performance of Covered Calls and Naked Puts 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.

This week, covered call trading and naked put trading were both profitable, as they have been for an extended period. That means the Bulls remain in control. 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.

STEP 2: How strong are the Bulls?

The performance of Long Calls and Married Puts 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.

This week, long call trading and married put trading were both profitable. Both forms of trading became profitable in late January. It means the Bulls are not only in control now, but they are confident and strong. 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, but they are 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 overstepped their authority?

The performance of Long Straddles and Strangles 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.

This week, long straddle trading and long strangle trading were both very near to returning profits. Profitability does not necessarily indicate that a market correction is imminent, but it is an important warning sign.

Profitability is a rare occurrence for long straddles or long strangles, so it is a good indication that the condition of the market is one that is rare as well. Profitability can sometimes signal that the market is topping out, while excessive profitability (in excess of 4%) is almost a sure sign that the market has reached a top and is about to correct. The 4% level has not been reached yet, but it wouldn't take much now. A couple of triple digit gain days for the Dow or the mid-1500s on the S&P is all it would take to push the LSSI over 4%. If that happens, look out below! 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 only been going up quickly, but have gone up surprisingly fast.” Profits warrant concern that the market may be becoming over-extended, 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 uptrend has been ridiculous and unsustainable.” No matter how much strength the Bulls have, they have pushed the market too far, too fast, and it needs to correct

Conclusion

The bulls retained control of the market this week. They also gained more strength this week, so much so that they are in danger of overstepping their authority if they continue to push stock prices higher. The S&P still has a little room to move higher, but not above 1580, at least not in the next few weeks. The same goes for the Dow, it still can go higher, but not to 14,600. Such large rallies, when combined with recent gains, would likely result in a significant correction. It is also possible that a correction may occur at any time now, without the market making gains first.

*Option position returns are extrapolated from historical data that, while reliable, cannot be guaranteed accurate. It is not possible to match the exact performances shown, because the strike prices and expiration dates used in the calculations will not always be available in actual trading. All data is relative to the S&P 500 index.

The preceding is a post by Christopher Ebert, who uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. He studies options daily, trades options almost exclusively, and enjoys sharing his experiences. He recently co-published the book “Show Me Your Options!”

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