A Unique Way To Maximize Income In A Bear Market

The traditional covered call strategy is considered a neutral-to-bullish approach. This is because profits are made when the underlying stock remains stable or trades higher. For this reason, most investors are more than willing to sell covered calls during periods when the market is generally rising, but the strategy often loses its popularity during bear markets.

Today, let’s discuss a novel way to use covered calls during bear market periods. Specifically, we’re referring to using covered calls on inverse ETFs, which increase in price as stocks fall.

Covered Calls 101

To start with, let’s revisit the basics of the covered call strategy. Using this approach, we buy a stock in 100-share lots. We then sell call option contracts against the stock. By selling the calls, we are creating income in our account, known as premium. In return for the income, we are obligated to sell our stock, provided it is above the option’s strike price before expiration.

This strategy performs best when the underlying stock remains strong. In most scenarios, our maximum profit occurs as long as the stock closes above the strike price when the option contract expires. On the other hand, we are exposed to risk if the stock falls. The premium we receive from selling the call options will help to offset our potential loss in the stock. But the lower the stock trades, the more our losses accumulate.

Inverse ETFs Turn the Tables

Inverse ETFs are engineered to trade in the opposite direction of a particular market or sector. Some inverse ETFs are also leveraged, meaning they are designed to trade two times or three times the magnitude of their underlying market.

For instance, the ProShares UltraShort S&P500 (NYSE: SDS) is designed to return twice the daily inverse of the S&P 500’s return. So if the S&P 500 were to drop by 0.5% for the day, one would expect SDS to rise by a full percentage point.

Inverse ETFs can be a helpful tool for traders who expect stocks to fall. They represent an opportunity to bet on falling prices without technically going short. These securities can be especially attractive for qualified accounts such as IRAs, which are not traditionally allowed to sell securities short.

Inverse ETFs also offer an interesting opportunity to set up a covered call strategy that has a bearish bent to it. Since most liquid inverse ETFs also have liquid option contracts, one could buy an inverse ETF and then sell calls against the position to generate additional income.

With this trade setup, maximum profits are made when the sector or market trades lower, driving the inverse ETF above the strike price. This allows us to profit from a bearish market environment.

One advantage of this strategy is that option contracts typically trade with a higher premium during bear market environments. This is because bear markets are historically more volatile than bull markets, and volatility is an important part of the option pricing equation.

This should help boost our returns with this strategy. But there are some important risks to consider when setting up covered call trades using inverse ETFs.

Unique Risks To Consider

Inverse ETFs (and especially leveraged inverse ETFs) have some unique characteristics that can work against our covered call positions. While these challenges don’t necessarily disqualify the approach, it is important to understand how these specific issues affect our returns.

First, we have the issue of how stock prices behave during bear market periods. It has been said that there is nothing more ferocious than a bear market rally. Even if the long-term trajectory of the market continues to be lower, a short-term rally can move prices very quickly. That’s because traders who are short often cover their positions and institutional money managers scramble to keep up with their benchmarks.

Since inverse ETFs are hurt by rising prices, a sharp bear market rally can lead to losses fairly quickly. It can even stop us out of our position before the bear trend continues. For this reason, it is important to give inverse ETFs a bit of extra room (possibly trading in smaller size) in order to account for an elevated chance of a significant bear market rally.

A second and perhaps more sobering issue is the challenge of volatility drag with inverse and leveraged inverse ETFs. Without getting into the statistical details, the bottom line is that volatility essentially erodes the value of inverse ETFs over time.

For example, if the S&P 500 index were to rise by 15 points on one day, and then fall by 15 points on the next, the index would wind up at the same level that it started. On the other hand, SDS (the leveraged inverse ETF) would actually lose a small amount of value over the two-day period because of the way the math works out. This loss is relatively small over a two-day period, but the decay can add up substantially over a longer time period.

Since volatility drag is greater for leveraged inverse ETFs, using a standard inverse ETF such as ProShares Short S&P500 (NYSE: SH) could lessen this risk.

Closing Thoughts

Now, we realize that this is a bit of a niche strategy. But if you have experience with options (particularly covered calls), then this may hold some appeal. Just realize that there are only specific times during the market cycle when this is likely to work.

The bottom line is that setting up covered call positions on inverse ETFs can be a very attractive strategy during bear market periods. But you should use it with a relatively short-term approach. Give the trade plenty of room for extra volatility that can come into play.

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