Sunday, December 6, 2009

Overall Market Meter -- A Revised Covered Calls Investing Strategy

The "Overall Market Meter" on the right sidebar of this blog reflects the Covered Calls Advisor's current overall stock market outlook, which is currently "SLIGHTLY BULLISH." The meter also shows seven possible market sentiment indicators: Very Bullish, Bullish, Slightly Bullish, Neutral, Slightly Bearish, Bearish, and Very Bearish. To determine which indicator is most representative of this advisor's current outlook, a quantitative-based, multi-factor decision model is used. An explanation of the nine factors used to determine which one of the seven sentiment indicators is most representative of this advisor's "Current Overall Stock Market Outlook" will be the subject of another article on this blog in the near future.

The purpose of this article is to present the Covered Calls Advisor's preferred investing strategy for each of the seven possible indicators. First, let's consider this advisor's primary objective with covered calls investing, namely to "achieve market-beating returns." To accomplish this, an investing strategy should be designed to provide an opportunity to outperform the market for each of the seven market conditions. Fortunately, a well-defined, disciplined covered calls investing strategy provides an opportunity to achieve that goal by investing more aggressively in bull markets (by selling out-of-the-money covered calls), and more cautiously in bear markets (by selling in-the-money covered calls).

The chart below summarizes the Covered Calls Advisor's strategy for each of the seven market outlooks, and also provides a side-by-side comparison showing the original strategy and the revised strategy:

As described in a prior article (link), one of the great things about covered calls investing is that it provides us with three potential sources for profit: options income, dividend income, and capital appreciation. During recent months, this advisor has determined that a slightly more aggressive posture is desirable to become more fully exposed to the capital appreciation profit potential of covered calls. This is achieved through greater out-of-the-money exposure when initially establishing covered calls positions. Two revisions that enable this result are:
(1) The "New Strategy" shifts the moneyness of the strike prices toward a slightly greater out-of-the-money stance when establishing covered calls positions; and
(2) In bearish markets, by substituting some out-of-the-money positions on short (i.e. inverse) equities for what would normally have been in-the-money positions on long equities. For example, the chart demonstrates that when the "Overall Market Outlook" is "Bearish," the corresponding "New Strategy" will be to have 50% of the total portfolio value invested in covered calls that on-average are 1% In-the-Money using long underlying equity positions with the other 50% of the portfolio value invested in covered calls that on-average are 2% Out-of-the-Money using short (i.e. inverse) underlying equities.

If you have comments or questions related to the contents of this article, please feel free to submit them by clicking on the "comments" link below. If you prefer confidential communications, my email address is listed at the top-right sidebar of this blog site. Your comments are always welcomed.

Regards and Godspeed,