Using covered calls to take advantage of volatility

One of the main reasons the stock market has been so strong in recent years can be traced back to the Federal Reserve and its low interest rate policy. For investors that seek yield, the stock market has been a much better vehicle for yield than traditional fixed income assets.

The flow of money out of fixed income securities and into high dividend paying stocks has helped the stock market enjoy a strong run in recent years, but volatility has become a problem. Every time the Federal Reserve hints that it will allow interest rate to rise, money comes out of the market, only to come back in a few weeks later. This volatility can be frustrating to investors, but it can also work in our favor by using a strategy such as a covered call on dividend paying stocks.

The best time to purchase a stock with the plan to write a covered call on it is during a time of high volatility or unsafe market. The primary reason being that option premiums tend to be greater when volatility rises. While this market is not exactly unsafe, it certainly qualifies as volatile.

First, let's discuss a covered call. To set up a covered call, you will sell 1 call for every 100 shares of stock you own. The act of selling the call brings additional income into your position, and thus leads to higher yield for holding to the stock.

There are two possible outcomes. One is that the stock closes expiration above your sold call strike price. In this situation, your stock is called away, and your option vanishes. This is not the ideal situation, but still acceptable. Since you want to sell a call higher than where the stock was originally, you not only get to keep the initial credit, but also book the gain made on the stock between the time of writing and the strike price. On the other hand, should the stock jump 15 percent higher than your strike, you miss out on the additional 15 percent gain, so you want to make sure you sell a call with a strike price that you comfortable selling your stock at should it cross that mark.

The other possibility is that the stock stays flat, or trades lower and closes expiration under your sold call. In this example, you keep your original credit, and still hold your 100 shares of stock. If the stock is flat, you basically added value to your portfolio you would not have enjoyed otherwise. If the stock turns sharply lower, the sold call helps counter balance the loss you have on the stock.

A lot of traders use covered calls on a regular basis, but I tend to just use them on positions that I am comfortable selling at the current price. If you follow this rule, then you never lose sleep over a position trading sharply higher than your strike price.

The best-case scenario is when the stock trades higher, but still closes at expiration just slightly lower than the sold strike. Since we are discussing volatile market conditions, this possibility is actually pretty high.

A lot of traders confuse volatility to mean the market is going to make a big move way one or the other. That is not exactly what volatility means. Volatility is big moves in both directions, so you can expect to see stocks make big moves in both directions. We have already seen this in dividend stocks, with dividend stocks hitting big selling pressure in the second quarter, but have already started moving higher.

Volatile markets boost premiums on calls, and if you add that to dividends that you would earn regardless, you can see how writing covered calls in a volatile market can be a great method to boost your portfolio's yield.

Michael Fowlkes

Michael Fowlkes

Michael Fowlkes is a financial writer who has been with the Fresh Brewed Media family since 2004. Over the course of his tenure with Fresh Brewed Media, he has worn many hats, including portfolio manager, options analyst, and writer. Michael received his undergraduate degree from Virginia Tech in Accounting and got his start in finance working as a stock trader for six years at Chase Investment Counsel in Charlottesville, Va.

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