Reverse Covered Call Writing: A Reasonable Bear Market Strategy? A Real-Life Example with SPDR S&P ETF Trust (NYSE: SPY) – December 05, 2022
Covered call writing is defined as first purchasing or already owning the underlying security and then selling the corresponding call option. By doing so, we are protected; we know our cost-basis. A BCI member proposed to me an extreme bear market strategy where a deep out-of-the-money (OTM) call is sold first and if the stock appreciates significantly, against market trend, we can buy that security prior to the strike moving in-the-money. This article will analyze the pros & cons of such an approach.
Real-life example with SPY
- 6/17/2022: SPY trading at $365.40
- 6/17/2022: The $400.00 deep OTM 7/18/2022 call shows a bid price of $1.56 per-share
- 6/17/2022: Sell the naked call first and plan to purchase SPY if the price appreciates near the $400.00 strike
BCI Trade Management Calculator showing initial returns at the current and $400.00 price points
The annualized returns whether shares are purchased or not, are between 4% and 5% (brown cells).
Strategy advantages
- In a bear market, holding long positions can result in significant losses
- Selling low-Delta, deep OTM calls have low probability of exercise
Strategy disadvantages
- The upside is the premium generated for a deep OTM call strike which, by definition for a security like SPY, would be miniscule
- If we are forced to buy the security as price approaches the deep OTM strike, the % return would be similarly miniscule, even a bit less (brown cells for 1st 2 bullets)
- Naked option trading requites a higher level of trading approval that most retail investors would have a difficult time obtaining
An alternative consideration
Sell deep OTM cash-secured puts that generate a pre-defined initial time-value return goal range because we know our cost-basis in advance (the cash required to secure that put trade). In this case, if the trade does turn against us and share price declines below the put strike, shares are purchased at a discount from when the trade was initially executed.
Discussion
There are many ways to craft our option-selling portfolios in extreme bear market conditions. Naked option selling is not appropriate for most retail investors even with a plan to purchase the underlying should the trade turn against us. In addition, it would be difficult to receive approval for such trading.
Author: Alan Ellman