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This Income Strategy Combines The Best Of Both Worlds

Wednesday, February 12, 2014 7:00 AM

The covered call strategy has some tremendous benefits. It allows us to boost the amount of income we receive from our investment portfolio, while also helping to protect our investments from losses if stocks trade moderately lower.

However, the strategy has one primary drawback. If the underlying stock that we own moves dramatically higher, our gains are capped. This is because our covered call strategy leaves us obligated to sell our stock to another investor at a specified price (the strike price) should the stock close above this price when the calls expire.

Generally, I'm happy to take this trade-off. I would much rather have a high-probability opportunity to make a solid 25% to 35% per year on my investments than a low-probability chance to make a much larger gain. After all, I consider myself to be a stable, systematic investor rather than a long-shot gambler.

However, there are times when the long-term opportunity for an investment is just too good to completely pass up by selling covered calls. But does this mean that we need to give up the income opportunity available to us as covered call traders? Not necessarily...

Creating Income While Still 'Letting Some Ride'
When I used to manage a covered call portfolio for a conservative hedge fund, I would often set up a "fractional covered call approach" for high-growth opportunities.

This approach is basically a hybrid that involves buying and holding a growth opportunity for long-term investment gains while still selling a smaller number of covered calls against the position to maintain a certain amount of reliable income in the account.

For example, I might buy 10,000 shares of a particular stock and then instead of selling 100 call contracts (remember, each call contract represents 100 shares of stock), I would sell a smaller number of contracts. If I felt strongly about the growth opportunity, I might sell only 30 calls. If my research showed a more moderate growth opportunity, I might sell 70 contracts and leave 3,000 shares unhedged.

While you may not be trading 10,000 shares at a clip in your individual portfolio, you can take the same approach by trading 200 or 400 shares and then selling only one or two call contracts against your position.

Balancing Income And Growth
The key concept to remember when setting up a fractional covered call trade is the balance between reliable income and speculative growth.

Covered call trades are by nature more reliable. Philosophically, we are giving up the potential for large profits in exchange for a more reliable short-term profit. Now, this doesn't mean that we can't enjoy a very healthy rate of return. After all, most of our covered call trades can generate between 25% and 35% per year. But it does mean that if a stock rallies 50% over a few weeks, we will miss a significant part of the move.

On the other end of the continuum, the typical buy-and-hold strategy relies exclusively on price movement to generate profits. If the stock moves higher, the buy-and-hold investor makes money. If the stock trades lower, the buy-and-hold investor loses money. If the stock remains flat, no profit is made. But in reality, when stocks remain flat, the buy-and hold investor loses because he misses out on the opportunity to create profits from his capital.

Using the fractional covered call strategy gives us a chance to capture some of the benefits of both trading approaches.

Selling a smaller number of calls against our stock position reduces the amount of income that we receive from a particular trade. But since our standard covered call approach targets 25% to 35% in income over the course of a year, we have plenty of room to give up some of that income in the hopes of generating a significant gain on our stock position.

From the perspective of a buy-and-hold investor, using a fractional covered call approach has the effect of diluting returns if the best-case scenario pans out. So if an investor owns 1,000 shares that rise by $5, and he had sold calls against half of the position, he may only receive $2,500 in profit from the unhedged stock portion of the trade versus $5,000 for the buy-and-hold investor. But he will also retain the cash he received for selling the calls, as well as potential gains on the hedged portion of stock depending on the strike price of the calls sold.

If the stock price remains the same of falls moderately, the covered call trader will come out ahead of the buy-and-hold investor thanks to the income brought in.

Targeting the Right Market Environment
When determining whether to use a fractional covered call approach and determining how many call contracts to sell against your position, it is important to study the overall environment for stocks, as well as the trading pattern for the individual sector that your stock is trading in.

During bear market periods, it makes sense to fully hedge your position (or even set up a ratio write where you are selling more call contracts than the number of shares that you actually own). Covered call traders benefit more from the income portion during bear markets because the premium price for call contracts is higher due to higher volatility in the market.

Conversely, during bullish periods, it makes sense to sell fewer calls against your stock positions.

First, the amount of income we receive from selling calls during bull markets is much smaller. This is because bull markets are typically less volatile, so options are naturally priced with less premium.

Second, the opportunity for investment gains due to rising stock prices is much higher during bull market environments. This is an obvious statement, but it is surprising how many investors do not adjust their trading approach to match the overall environment for the stocks they are trading.

Action to Take --> The key concept here is to be aware of the overall market trend, and then be willing to adjust your trading approach to best take advantage of that trend. As in most ventures, those who pay attention to their surroundings and adapt will beat those who stick with a rigid, outdated framework.

This article originally appeared on ProfitableTrading.com:
This Income Strategy Lets You Have the Best of Both Worlds

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Zachary Scheidt does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.