This Strategy Could Protect Your Wealth in the Next Bear Market
Bear markets bring lower prices and increased volatility. The increase in volatility is at least partly caused by the lower prices. As prices fall in a bear market, investors become worried that prices will continue falling. These worries will lead many investors to sell, and this adds to the downward pressure on prices.
We can see both of those forces at work in the chart below for SPDR S&P 500 (NYSE: SPY).
Volatility moves higher in a bear market and it remains at elevated levels for some time. Sustained volatility could be helpful to traders looking to minimize their losses in a bear market.
Covered call options can help investors boost their profits at any time. This is a conservative strategy that generates income from exiting positions in your portfolio.
A call option gives the buyer the right to buy a stock at a predetermined price (called the “strike” or “exercise” price) for a predetermined amount of time. Call sellers have an obligation to sell the underlying shares to the buyer if he exercises his right.
With a covered call, you sell a call option on a stock that you own. The risk is that you have to sell the stock if the price goes up and accept the profit you agreed to when you sold the call.
One benefit of selling calls is you are able to offset losses if the stock falls.
As an example of how covered calls can work, consider Apple (NASDAQ: AAPL). If you own 100 shares of AAPL, you can sell one call option. Each options contract covers 100 shares (although there are a few high-priced stocks that offer options covering only 10 shares, AAPL being one of them).
With AAPL, you can sell an option with an expiration date in one month. Calls with an exercise price about 5% above the market price of the stock might be selling for about 0.75% of the stock’s market price. This means if AAPL is trading at $450, you could sell a call with an exercise price of $495 for about $3.40. Since each call is for 100 shares, your total income would be $340.
If AAPL is trading below $495 when the call expires, you keep the $3.40 per share as income and you are free to sell another call. Doing this 12 times in a year could generate income of $40.80 a share if the price of AAPL remains relatively unchanged.
If the price rises beyond $495, your shares will be called away at that price. If the price declines, the income would help preserve your capital and you would not endure the full effect of the loss.
When the dividend is added to the options income, you could be enjoying income of more than 10% a year whether AAPL’s price goes up or down.
The price of the option, $3.40 in this example, is determined by a pricing model that considers a number of variables. The variable with the largest impact on the option’s price is the volatility of the stock price. In a bear market, as volatility increases, we would expect to see the prices of options rise.
Instead of trading at 0.75%, that one-month call on AAPL might be worth 1% of the stock’s price. Therefore, income on a stock could top 12% a year in a bear market.
AAPL is of course only an example. This strategy can be implemented with any stock you own that has options available on it, which includes almost all large-cap stocks.
Selling covered calls on stocks you consider to be long-term holdings is a great income strategy in any market environment. And it could be one of the most profitable strategies in a bear market when the prices of options will be higher.
[Note: If you’re interested in learning more about how you can use options to generate income in any type of market, then I urge you to check out my presentation. I’ll tell you how a glitch I discovered in the options market could be worth thousands of dollars per year to traders. Click here to watch.]