Market Timing with Covered Calls

03/14/2011 12:01 pm EST

Focus: OPTIONS

Rather than trying to time the market, learning to implement a covered call strategy on regular, longer-term holdings will allow for potential profits even during market corrections.

By the Staff at BornToSell.com

Market timing is notoriously hard to do. Trying to time the market with short-term trading and knowing when to buy and sell causes a lot of stress, and while it has the potential for quick profits (the attraction of the strategy), it also has the potential for quick losses (often the reality).

A more consistent strategy is to buy stocks that you are comfortable holding long term through the inevitable corrections, and then write calls against them each month. But that doesn't mean you shouldn't adjust your call positions as the market moves around.

"Ok. But if stocks drop, what do I do?"

The first question to ask yourself is, "Do you still like the underlying stock?" Has anything changed with its fundamentals or prospects? Are the reasons you originally bought it still intact? If so, then rather than selling the stock when it drops, a covered call writer can simply buy back the call, which presumably, has dropped alongside the underlying, so there will be a profit on the option side of the trade. Then, you can wait for the stock to recover a bit and sell another call against it.

"Great. But when do I know it's time to buy back the calls?"

Not an easy question to answer. Although, if you follow your stocks closely, you should get a sense for how volatile they are (or are not). A 5% drop in one stock may be a significant event, or it may be a common occurrence, depending on how the stock typically behaves.

But if you look at timing from a macro level, you can get a sense of when to buy back your calls from market-as-a-whole patterns. For example, look at how last November compares to the last 30 days:

chart
Click to Enlarge

Notice in November that there was a correction followed by a continuation of the bull market. The second half of November was a good timing opportunity to buy back your calls and then resell them pretty much anytime in December as the market continued higher.

The same thing could be true now. With the market off 200 points in one day recently, and several hundred points off its February high, now would be a reasonable time to buy back your short call options. Then wait until the Libya situation has less uncertainty. Once that happens, the market will probably rise several hundred points, and that would be a good time to sell new call options against your stocks.

Market timing is not something you want to do every day, but certain moments are reasonable places to make a trade by buying back your call options. If you're not sure, then you can do half: Buy back half of your calls and let the other half stay right where they are.

By the Staff at BornToSell.com

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