Market Timing With Covered Calls

by Mike Scanlin

Market timing is notoriously hard to do. Trying to time the market with short-term trading, and knowing when to buy and when to sell, causes a lot of stress and has the potential for quick profits (the attraction of the strategy) and quick losses (often the reality).

A more consistent strategy is to buy stocks that you are comfortable holding long-term through the inevitable corrections, and then write calls against them each month. But that doesn't mean you shouldn't adjust your call positions as the market moves around.

Ok. But if stocks drop, what do I do?

The first question to ask yourself is: Do you still like the underlying stock? Has anything changed with its fundamentals or prospects? Are the reasons you orginally bought it still in tact? If so, then rather than selling the stock when it drops, a covered call writer can simply buy back the call which, presumably, has dropped as the underlying has dropped, so there will be a profit on the option side of the trade. Then, you can wait for the stock to recover a bit and sell another call against it.

Great. But when do I know it's time to buy back the calls?

Not an easy question to answer. Although, if you follow your stocks closely you should get a sense for how volatile they are (or not). A 5% drop in one stock may be a significant event or may be a common occurance, depending on how the stock typically behaves.

But if you look at timing from a macro level, you can get a sense of when to buy back your calls from market-as-a-whole patterns. For example, look at how last November compares to the last last 30 days:

Dow Jones INDU Last 6 Months (Sep 11, 2010, to Mar 10, 2011)

Notice in November there was a correction followed by a continuation of the bull market. The second half of November was a good timing opportunity to buy back your calls, and then resell them pretty much any time in December as the market continued higher.

The same thing could be true now. With the market off 200 points today, and several hundred points off its February high, now would be a reasonable time to buy back your short call options. Then wait until the Libya situation has less uncertainty. Once that's true the market will probably rise several hundred points, and then that would be a good time to sell new call options against your stocks.

Market timing is not something you want to do every day, but moments like today are reasonable places to make a trade by buying back your call options. If you're not sure then you can do half -- buy back half of your calls and let the other half stay right where they are.

Mike Scanlin is the founder of Born To Sell and has been writing covered calls for a long time.

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