Covered Calls Revisited

Heather Cullen

Heather Cullen

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In The Money

Bull Market Sleeping in The Money Heather Cullen

While the bull market sleeps . . .

Well, here we are, out of the market, sitting on our hands. Our ‘back in’ signal seems quite a way off, as does a bear market. SPY is down 10.5%, so we are just into correction territory.

Being out of the market is really frustrating, and you are tempted to do something just to alleviate the boredom. But what to do? I have been revisiting covered calls and thought I would share my observations. If you decided that you were not going to sell but sit through this downturn, then you may be interested in this approach.

Volatility Effect

When we last looked at covered calls (https://heathercullen.com/are-covered-calls-worth-it/) volatility was very low, and hence options were cheap. When options are cheap you want to be a buyer; when they are expensive you want to be a seller. We looked at selling an OTM call 5 days to expiry, and compared strikes of 2%, 3%, 4% and 5% above the current price. We saw that the only one with a bid was 2% and that was 2 cents, which clearly wasn’t worth it.

What a difference volatility makes! Here are the current offer prices:

ITM SPY 5 day options

Today, if we go 2% above the current price, we get $1.70 instead of $0.02. If we could do that every week for a year this would give us a 21% return (assuming that we were never exercised.)

Getting Closer

But is there a way to improve on this? Looking at the 2 days to expiry we have the following offer prices:

ITM SPY 2 day options

Less, of course, but still interesting. I analyzed the SPY movements on Mon / Wed / Fri over the last 2 years. I assumed 2 trades a week, the first buying Monday and selling Wednesday, the second buying Wednesday and selling Friday. When I checked to see how likely it was that the strikes would be hit, I found:

SPY 2 Day Change ITM

To me, the 2.5% looked interesting as the probability is that you get exercised approximately once every 50 trades. Let’s check the bid/ask for a strike 2.5% above the current price: $0.59, or $59 for the contract. There is a 2% chance that you will be exercised but remember that means you will be selling SPY at 2.5% over the current price when you sold the option. If you do this twice every week for a year, then your return would be 14% (assuming that options prices stayed at the same level).

SPY Option Chain 10 Mar 22

 Clearly, a return of 14% is not going to set the world on fire, but if you are holding shares of SPY then it is better than nothing.

But I sold my options!!

Which means you are nice and safe during the current volatility. If you want to play, however, then there are ways to do this relatively safely: one way is calendar spreads. This is where you buy a longer dated (say, 3 – 6 months) ITM call and then sell weekly OTM options against it. It lowers your risk (because you can’t lose more than the cost of the option) and increases your return (because your denominator will be the price of the option not the price of the shares).

Should I do it?

Only if you already hold SPY shares or with play money you are prepared to lose. Am I doing it? Yes, on one account. I have an account that has 1000 SPY and 1000 QQQ shares (not recommended, long story) and this strategy netted $4K last week. I deliberately didn’t do it this week as I was expecting a bounce, but now that it has happened, I will watch the market open and probably sell some OTM Friday calls (2 days away).

Which options should I buy?

Compare Option Strategies

I have just published Compare Options Strategies which is half textbook and half workbook. It concentrates on one-leg strategies, and I intend (later in the year) to write some follow up books with more complicated 2, 3 and 4-leg strategies. But the simple strategies have to be thoroughly understood first so it is a good place to start. The textbook part gives you a crash course in market signals and candlesticks, and the workbook guides you through different options. You can do just paper trades (on a demo account) or you can mix paper and real trades.

If you want to try out some simple option strategies here’s the link: Compare Option Strategies. It is not suitable for eBook format, and is in paperback and hardback (although the hardback is showing as ‘out of stock’ – why, Amazon??). It is A4 (desk sized) so that there is plenty of room in the workbook for you to record all the details of your trades.

Where to from here?

There’s nothing happening on the ITM front. We are waiting for either a golden cross to get back in, or to descend into bear territory (SPY down to $382) then we can get ready to trade the bear.

Until then, its probably a good time to learn more about options and practice trading them – with paper trading or play money of course!

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