Been a Long Time Coming

After beginning a run up in July 2006, the market sold off beginning in late February 2007 and bottomed in in March. That advance saw a gain of approximately 2,000 points in the Dow Jones Industrial Averages (INDU).
Since that March bottom we're up roughly 2,000 points on the Dow - again - wthout a major correction yet.

So I have two concerns now.

One, I'm expecting a correction of 700 points or more. Like the one in February/March. I won't go into the arcana of retracement theory, but all markets need to correct from time to time in order to balance long- and short-term selling and buying pressures. There was a short-term correction in June of about 440 points, which bled some steam off no doubt, but no one who (like me) believes in retracements thinks it was enough of a correction. I suspect more correction is needed, and it came too soon after the March correction. The following chart illustrates recent corrections:

The second concern is that the market is toppy and a new bear market is looming. There isn't room here to talk about the problems with our economy, but a bull market depends for fuel on the overall economy. The main issue
now (not the only one) is the housing market. Americans on the whole don't save; our houses are our piggy banks. Approximately 75% of the increases in our Gross Domestic Product in each of the last few years, according to Economist John Mauldin, came from home equity loans. That was quite the spending spree. Now with much tighter lending standards, that source of spending money is much reduced, and corporate spending is not taking up the
slack.

Note also that we've been in a bull market since very early 2003, over 4-1/2 years. From 7,416 to 14,000 points for the INDU, it has been a nice run. Now, that is a long time for a bull market. No matter what your view about the market at this instant, I think you will agree that none of them lasts forever. Trust me, we have not broken through to a new paradigm in human nature in which bear markets have been eliminated.

A lot of players in this game, including huge ones, are riding the bull rails as long as possible. But everyone knows the end of the bull ride is coming. A convincing spark is all that it will take to ignite a new bear market. I think it will happen when a slate of poor earnings are released, although a hike in the FedFunds rate could do it. More to the point, I wonder: where is the economic energy to take the market higher.

This bull market will end, also. But when?

I don't know when a correction is coming, much less the end of the bull market. Sentiment indicators like put/call ratios, the VIX and VXN and similar indicators are of little help in calling market tops, though very helpful in calling bottoms. The strength of this market through what normally are the summer doldrums has been a surprise. Maybe the market is headed to 15,000, even - I'm hearing that sort of thing, which is scary.

Still, the fact that we don't know the "date" the bull ends doesn't mean that we should ignore the possibility, and perhaps take it into account in writing covered calls.

Correction or New Bear Market?

The interesting thing is that, if a correction begins soon, we will not know immediately whether it is in fact just a correction or the initiation of a new bear market. I was convinced the March sell-off was only a retracement and that is what I told CallWriter members. I was so convinced because 1) the housing market blues weren't quite so blue then, and 2) the market was due for a good retracement, technically speaking. I could have been surprised, of course.

We appear about due for another correction. In fact, it may have begun today, down 134 points on the INDU as I type this mid-afternoon.

Reaction to the March sell-off was very panicky. A lot of people sold the underlyingstocks in covered call trades at a loss and got out. Holding those stocks a little longer would have seen them (or at least the high-quality stocks) recover just fine not long after the sell-off began - the reason that call writing should be confined to the best companies. In fact, some really strong companies hardly sold off at all.

Some writers even abandoned covered writing as being too unpredictable. But there is another strategy that should be considered if a correction comes, or is here now.

Protecting the Trade

Before discussing the protective put strategy below, let's look quickly at a couple of other options.

Rolling. The easiest way to protect the trade is to simply roll the calls down, or down and out. This means to buy back the short calls and sell calls with a lower strike price. Thus if you buy the stock at $20 and write the 20 Call for $1.00, if a pullback in the stock has you concerned, you could buy back the short 20 Calls and sell 17.5 Calls. This is only sensible if there is lots of time value in the ITM calls and you don't wait too long to roll down. Rolling out a month also adds more premium. The key of course, is whether the roll improves your position, if called out. If it doesn't, then do not consider rolling. End of story.

Closing. You could also close, but I never close a trade at a loss unless 1) I am convinced that a much bigger loss is coming if I do not, and 2) closing seems like a better alternative than buying puts, rolling down or taking other action. If a stock seems in real trouble (it's prospects seem to have materially deteroriated), I may close. However, even in this circumstance, buying the right protective put can offer great protection and make it possible to keep pulling call income out of the stock.

Maybe it is a macho thing. But the entire reason for confining our call writing to the best companies is that we wind up with the strongest, most reliable and resilient stocks. Therefore, stopping out of a trade at a loss is something I do very seldom. Now let's talk about a strategy that has very little risk, done right.

Protective Puts. Everyone knows that a protective put can be purchased on the underlying stock in a covered call. The problem with buying a current-month put is that the put premium, if close enough to the money to be truly protective, will consume most of the call premium. Not good. Plus, any long put still leaves an exposure gap.

But consider buying a longer-term put. For example, if you have written the current-month JUL calls and the stock is pulling back, consider buying a NOV, DEC or JAN put. Sure, it will cost more than the call premium received, but that does not matter. The put protects the stock (up to the put's strike price) all the way through put expiration. This frees up the writer to keep writing calls every month until the put expires. Even if the stock later moves up in price, the put still will offer some protection. The put also eliminates the concern that the stock is dropping. Keep writing calls. If called out, buy the stock again and keep writing, because the protective put ultimately makes the stock someone else's problem.

In addition to protecting the stock, as the stock continues to fall the put will become more valuable. Assume that the stock pulls back and you believe it has bottomed. Perhaps the stock has formed a new base, or it went down
with a market correction and the market is coming back - whatever. You can sell the now-more-valuable put at a profit. Once the stock recovers its price, the put will be back roughly to the value at which you bought it, but I don't hesitate to sell the put once I think the danger is over and the stock is recovering. After all, trading the options can be a major part of the return from covered call trades.

It is key not to overpay for the long put. In our example above (buy stock for $20, write 20C for $1.00), I would not pay more than $3.00 to $3.50 for the longer-term 17.50 Put once the stock began dropping. In fact, sometimes when I close the trade it is because protective puts are ridiculously priced. I will not really pay more than about 3-4x the call premium. The multi-month protective put works best where the puts are cheap in relation to current-month premium. There is little point to buying a multi-month protective put six months out if the premium is 6x the call premium! How likely would it be to recoup that put premium once implied volatility diminishes and call premiums go back to a more normal level?

I buy puts at least three expiration months out, because I want some operating room, not being forced to make a decision too soon. If the put's remaining life is too short and the stock has not made a recovery by put expiration, it pretty much forces you to exercise the put - but you have had little chance to sell calls in the meantime, which is one of the reason to buy puts in the first place.

Of course, at some point during the stock's pullback we would buy back the short calls, or let them expire worthless if close to expiration. Once the stock recovers its price, write more calls. If it doesn't recover, of course, then wait for the stock to establish a new trading range before writing more calls. Or exercise the put and put the trade behind you.

That is the beauty of the multi-month protective put. It puts you in the driver's seat.

So if the next correction comes, onsider buying multi-month protective puts. If the market dips for a few days or a couple of weeks and comes back, you can sell the multi-month put for pretty much what you paid. If there is a
real correction, sell the put at a big profit once confident the correction is over (close the call, too) - before the stock recovers all the pullback. Or exercise the put and don't look back. It's your choice when the trade is protected.

If you are supremely confident that a market selling-off is just a temporary correction, you need take no action. At this point in the bull market, though, I'm not sure how one could be totally confident in that assessment. I wouldn't be. But even if you were, doesn't the long put play simply provide another source of return?

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