How to Make Use of Covered Calls in a Bear Market

The Purpose of Covered Calls Selling in a Bear Market

A bear market may be a traumatic experience for long-term investors, particularly for those who are nearing or have reached retirement age. Bear markets have the potential to wipe out multi-year profits and the losses might be particularly severe for elderly retirees who do not have as much time left to participate in the stock market. As we all know, predicting the precise time and severity of a bear market is extremely difficult. However, there are various strategies you may use to protect your portfolio against a downturn in the stock markets. For example, you may sell covered calls against the equities in your portfolio. As a result, you won’t have to worry about selling everything and moving into cash.

Selling call options against a long-term equity portfolio allows you to generate income that can help you recover some of your investment losses. Thus, covered calls can be used to produce revenue and reduce losses when the market is in a downturn. Put options that provide protection against serious adverse market movements are viable. Here are the tips to follow if you find yourself in a bear market.

Sell Covered Calls Only on Financially Sound Companies

You should only invest in companies that are among the best performers in industries that aren’t adversely affected by the economic situation. To that end, ensuring that your underlying equity portfolio is comprised of high-quality companies is imperative. These firms will have the strongest recoveries following the end of the bear market.

Only Write In-The-Money Calls in Bear Market

It is a good idea to write in-the-money calls in any market, but it is especially pertinent when the market is sinking. Writing in-the-money calls is possible to miss income potential and to miss out on any capital gains if the stock price rises. Writing a call with a strike price that is lower than the current share price, on the other hand, will give you with substantially more downside protection. The protection is more than just writing the call at the money or out of the money. As we all know, when the markets are in a downturn, a greater amount of protection is essential.

An ITM call provides much more downside protection than an OTM call.

An example of an OTM call is seen in the graph above. Although the upside profit potential is far greater than that of an ITM call, as seen in the graph below, the downside protection provided by the ITM call is significantly greater. When the stock price reaches $147.91, the out-of-the-money call begins to show a loss. Despite this, the ITM call does not exhibit a loss until the stock falls below $139 in price.

Protect Your Covered Calls by Adding a Protective Put

It is possible to utilize long-term protective puts in combination with short-term covered calls in order to give complete downside protection. In some circumstances, the revenue from covered calls can be used to offset the cost of a protective put option. The advantages of a longer-term put are that it may provide protection for several months at a time. Moreover, it is more effective at retaining its value than a short-term put may be. This is due to the fact that the time value of a longer-term option decays far more slowly than the time value of a shorter-term option.

Protective puts should be added to your covered calls to help ensure that the loss is kept to a minimum.

Summary

At the end of the day, in a bearish market, safety reigns supreme. You want to keep your nest egg safe by limiting the amount of money you lose. While adverse market circumstances are present, your portfolio should continue to generate income while also maintaining its value by employing the covered call selling technique in conjunction with protective puts.

Leave a comment

Your email address will not be published. Required fields are marked *