Recessions often lead to a drop in stock prices, as slowing revenue lowers valuations. While some investors choose to ride it out or shift their portfolio into cash or bonds, options can help you stay in the market, hedge against downside risk, and generate income.
In particular, covered calls can be an excellent way to survive and thrive in a bear market.
Let’s look at why covered calls may be a good idea during a recession and four bear market strategies to consider for your portfolio.
Why Use Covered Calls?
Covered calls involve writing (selling) call options against a long stock position to generate premium income. Since you only agree to sell the stock you already own, the only risks are the underlying stock losing value or missing out on a price increase above the strike price. As a result, covered calls are a low-risk income strategy for neutral to mildly-bullish markets.
However, covered calls can also be helpful during bear markets. As volatility increases during a bear market, you can generate more covered call premium income.
At the same time, the extra income can offset losses while enabling you to stay in the market. And, of course, you can always add more protection when you need it.
4 Bear Market Strategies
#1. Write In-the-Money Calls
Writing call options with a strike price below the current stock price (in-the-money) provides more downside protection than at-the-money or out-of-the-money call options. After all, you can generate more premium income to offset any decline in the underlying stock price. But you still have to be careful when writing in-the-money call options.
A common mistake is writing in-the-money call options several months out when a stock experiences a significant (10%+) decline or approaches a support level. If the stock rebounds, you may have to buy back the short call at a much higher price. Or worse, the rebound may be temporary, leaving you with a higher cost basis from closing the option!
If a stock starts to drop, in-the-money options are easier to roll down to capture more value. However, you should avoid rolling options to a strike price below a strong support level until it’s clearly broken. Otherwise, you could fall into the same trap as writing long-term in-the-money call options and buying back the short call at a higher price.
#2. Select Safe Trades
Covered calls involve owning a long stock position without any downside protection aside from the premium income. While stock picking isn’t hard during bull markets when everything is trending higher, bear markets introduce a lot more risk of significant declines in the underlying stock. So, choosing the right stocks is essential to protect against losses.
Some characteristics to look for include:
- Value – Stocks with a valuation below their peers may have a more significant margin of safety than high-flying stocks. Some metrics include price-earnings (P/E) or price-book (P/B) ratios.
- Growth – Stocks with growing revenue and net income are less likely to experience a decline since they’re creating value for shareholders in the near term rather than in the distant future.
- Momentum – Stocks with favorable technical indicators (e.g., momentum) may be more likely to continue moving higher than those stuck in a bearish downtrend.
In addition to these metrics, look at specific sectors well-positioned to navigate a bear market. For instance, consumer staples and healthcare stocks tend to outperform during a bear market. Meanwhile, you should avoid technology, telecom, or consumer discretionary stocks that may perform worse.
#3. Add a Protective Put
Covered call holders can use protective puts if they suspect the underlying stock will experience a short-term correction. In many cases, current-month or next-month puts offer enough delta to be defensive. However, in-the-money puts for the current month may erode quickly if the stock rebounds due to its high intrinsic value.
If you’re interested in longer-term protection, you might establish a collar by purchasing a long-term put option. But, of course, the amount of protection you receive will impact the covered call’s income potential. The worst outcome is choosing a put strike price that the stock price hits, causing your call and put options to expire worthless.
#4. Build a Flexible System
Most successful traders and investors have a fine-tuned trading system or strategy. For instance, you might have specific technical and fundamental criteria that a trade must meet before entering a position. And then, you may have rules surrounding when to roll out or roll up a covered call or convert it into a collar.
And remember: The best course of action may be doing nothing. For example, if the markets move sharply lower intraday, you may want to wait for the dust to settle before entering or exiting a position. Or, you might employ a very conservative strategy, only entering into a covered call position when a stock is above its 50-day moving average.
The Bottom Line
Covered calls are a popular way to generate income from a long stock portfolio. While neutral to mildly bullish markets are optimal, the strategy can also help generate income and protect your portfolio during a bear market. However, you’ll need to make a few adjustments to your plan to avoid taking losses during these turbulent times.
If you’re interested in covered calls, the Snider Investment Method provides a well-thought-out approach for finding covered call opportunities, generating income from them, and managing them during any market conditions. We also offer everything from trading tools to asset management solutions to help you succeed.
Take our free covered call e-course today!
