Is It a Good Idea to Use Covered Calls in a Bear Market?
Investors use covered calls when they plan to hold the underlying stock for a long time. Meanwhile, they don’t expect any sharp price changes in the near future. By simultaneously holding stock and selling covered calls, an investor can potentially increase returns and lessen exposure to risk. In a stagnant or declining market, the covered call premium could help you turn a profit or at least break even.
In times of high volatility and a downward trend in the stock market, this is especially true. Long-term shareholders who own shares of companies with solid fundamentals may find selling covered calls to be a useful strategy during a bear market.
Most of the time, a covered call is bearish because the trader is selling calls that are deeper in the money and have a higher delta. This might potentially counteract the stock price decline. Using time decay in options, the technique can still produce a modest return.
Covered Call Selling Strategies for a Down Market
First, think about the next 30–45 days, but use your best judgment. You should try to sell the call option at the desired strike price on a date that yields a satisfactory premium. Some investors seek out deep in-the-money calls so they can sell covered calls with adequate downside protection in a bear market. The time value of these calls should still be between 0.5% and 2%. Because of this time decay, investors can make money off of the options premium.
Here’s a real-world illustration of how to use covered calls to weather a market decline. In the following table, you’ll find information about trading covered calls for The Chemours Company (CC). The stock started a steady decline after I bought shares in July 2021 and then sold covered calls on those shares. This table shows how the monthly covered calls were sold. If the covered call were to be exercised and the stock were to be called away in December 2021, I would make a 5% profit within 6 months. Without the covered calls, the buy-and-hold strategy would result in a loss of nearly 7%.
What Is the Risk of Covered Calls?
There is serious risk in pursuing any investment strategy that involves stock ownership and options trading. In this situation, the main goal of any trader should be to reduce the amount of risk they are exposed to.
It’s crucial that you know the ins and outs of covered calls and how to implement them into your portfolio. The breakeven point for covered calls is the difference between the stock purchase price and the options premium received. If the stock price drops below the breakeven point, there is a genuine danger of losing money. As a result of the downturn in the market and the volatility of stocks, it is likely that the share price will drop below the covered call strike price. As a result, even the time value from the options premium is insufficient to sustain the steep drop.
Covered calls are the optimal strategy for long-term investors who own shares of financially stable companies. Options trading is difficult and not recommended for everyone. Find out how comfortable you are with taking risks before you make any big moves. Using covered calls as part of your risk management plan is one way to possibly make more money while reducing losses.
Takeaway Points
In any market environment, selling in-the-money call options is a sound investment strategy. However, in a falling market, its significance increases. If you want more downside protection than from an at-the-money or out-of-the-money call, write one below the current share price. But this method will lower your income potential and prevent you from participating in capital gains if the stock rises. Having a safety net is especially important during bear markets.
There is a way to further safeguard your investment. That is, you can purchase a put option to hedge your covered call investment. A longer-term put offers more security than a shorter-term put. Plus, it retains more value over time. This is due to the slower time value decay of a longer-term option in comparison with a short-term option.
There are times when inaction is the best strategy. There is the bear market, and then there is a total market collapse. In volatile markets, writing covered calls can be profitable. However, it’s preferable to sit on the sidelines in the event of a catastrophic downfall. Keep cash on hand. Bear market covered call writing can be profitable if you know what you’re doing and take safety measures.