Submitted by William Briat as part of our contributors program.
How to Generate Premium Income in a Stalling Stock Market
The S&P 500 recently traded at a record-high, just before tensions in the Ukraine erupted and the global stock marketdeclined as fear of an escalation and war intensified.
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While the charts continue to show the stock market wanting to move higher after excellent gains in February, I still sense the upside moves will be more difficult to come by compared to what we saw in 2013. Even at this point, the Dow Jones Industrial Average and the S&P 500 are still negative this year.
If the stand-off between the Ukraine and Russia doesn’t escalate, I would expect the stock market to advance higher by year-end. If tensions erupt in the Eastern European region, we would likely see major selling across stocks worldwide; commodities such as gold, oil, and grains would edge higher.
If the stock market fails to find its footing—and especially a fresh catalyst—we could see mixed and volatile trading in the months ahead as the market looks for direction.
And if the stock market fails to get any positive leverage heading into the summer months, we could see some stalling in the stock market.
If the stock market does stall, an investment strategy to consider would be to write and sell some covered call options on your stocks in order to generate some premium income. This would also help to lower the average cost base of your positions, while also setting a selling price you would be willing to sell your stocks at. Of course, your goal would be to generate premium income and not look to sell stock, as I believe the stock market will head higher.
When writing covered call options, this implies you own the underlying stock position; otherwise, it would be a naked call option, which is not what you want due to the inherently high risk.
Also keep in mind that writing covered call options means you are willing to sell your stock in the case the stock rises to the strike or exercise price you set when writing the call option. So be careful when setting the covered call option strike price—too low and you can be called away prematurely if the stock market quickly surges. Carefully select the strike price based on the resistance levels of the stock, especially if you do not wish to be called away.
For example, say you own shares of The Proctor & Gamble Company (NYSE/PG). The current price is $78.46 as of Tuesday, but you think the upside over the next few quarters is limited in the current stock market climate. You can generate some premium income by selling a covered call option on Procter & Gamble and reduce the adjusted cost base. Now, say you are comfortable with selling Procter & Gamble at $85.00; you can write the October $85.00 call option and bring in $2.63 per share in premium income. If Procter & Gamble fails to reach that level by the expiry, you would retain the premium. If Procter & Gamble does trade above the strike price by the October expiry, you would be required to deliver your stock at the strike price, but you would’ve made a nice return.
So if the stock market does look to be stalling, writing covered call options makes a whole lot of sense.
This article How to Generate Premium Income in a Stalling Stock Market was originally published at Daily Gains Letter