Deep in the money calls can be an exceptional strategy to consider in a bear market. Whipsaw days and high volatility can make it tough for any investor. Wouldn’t it be great to put aside all the wild swings, volatility and fear of the bear market and get back to what is really important, investing. That’s what deep in the money calls can provide.
There is a difference between trading and investing. Traders are often in the market for short periods, sometimes even minutes as they try to make quick profits. Investors on the other hand are trying to look for value in a stock and turn a profit but not overnight.
The problem for a lot of investors is that buying stocks in a bear market can be down right terrifying. Again this is where deep in the money calls as a strategy for bear markets can be a winning strategy.
Everyone knows what deep in the money calls means. You buy the stock and sell covered calls that are below the stock valuation at the time of purchasing the stock. Seems simple, but actually there is more to deep in the money calls if you want to end up with profits and protection during bear markets.
The bear market we are in now (Nov 2011) could be far more severe than anyone can realize. However sitting on the sidelines with all my money in cash is a tough position to be in. Cash is earning next to nothing so instead I like to consider deep in the money calls as a strategy to keep investing despite the market conditions.
Deep In The Money Calls Can Work In An RRSP
In Canada, retirement portfolios that are registered to reduce taxes are called Registered Retirement Savings Plans, or RRSP. In Canada there are also Tax Free Savings Accounts or TFSA. Both of these have terrific benefits to reduce income tax, but they have more restrictions than our neighbors in the USA. In Canadian RRSP and TFSA, we cannot sell puts. This is a disadvantage. However we can sell deep in the money calls and planned properly, this can be a great strategy for an RRSP.
Deep In The Money Calls – My Steps To Profit & Protection
Many of the steps I take when putting in place my deep in the money calls are the same ones I use for many of my strategies. In a bear market, stocks, even great ones, fall. A bear market is not selective. Because of this I stay away from speculative stocks, juniors, and emerging market stocks. I turn to the large capital stocks. The more diversified they are, the better. These are the big boys and they will in my opinion survive a market collapse. They should pay a dividend and there has to be decent option premiums.
Why Large Cap Diversified Stocks?
I started investing in 1973 and lost a lot of my capital in that bear market. Many of the stocks I held were juniors, speculative stocks and a few large caps that were not very diversified. I knew little about stocks and relied on my broker. The market crash in the mid 1970’s saw stocks fall almost 50%. In the next 10 years more than half of my stocks disappeared. 80% of the juniors disappeared along with all the speculative stocks. Of the few large caps I had, more than half recovered within 3 years. Those that recovered were the most diversified. This taught me a valuable lesson. Large Cap diversified stocks have the best chance of recovering to their past trading ranges and that means my capital also has the best chance of recovering.
Deep In The Money Calls – The Stock, The Call Premium, The Downside
The steps I use for deep in the money calls are straight forward. I review various large caps and look at the deep in the money calls about 2 to 4 months out and see what premiums are available. I plot those premiums out and see what my cost basis would be in the stock should it fall beyond my deep in the money covered calls.
I then review the history of the large cap stock going back about 3 years and pinpoint areas of weakness to determine what strikes would be best to sell the deep in the money calls at.
I then determine levels I would buy back my deep in the money calls should the stock fall too far and what strikes I would sell next. By having a plan in place I can make decisions without emotion. I know in advance what the action plan is and when it will be implemented.
The best way to understand the strategy of deep in the money calls is to look at a few stocks.
Deep In The Money Calls – Exxon Mobil Stock
For my first example I will select Exxon Mobil Stock, with the stock symbol of XOM. For this article I am using charts from Oct 7 2011. XOM stock was trading at $73.56.
The first thing I do is look at the deep in the money calls premiums for 2 months and 4 months out. I sometimes select a closer month, but by selling deep in the money calls, 4 months out I have found that the premiums provide good protection and a reasonable return but also allows enough time for the stock to fall and recover. I have found over the years that about 75% of the time my 4 month trades work out and provide reasonable returns. That said, it never hurts to look at closer months to see what premiums are available. I can then calculate possible returns and percent of protection from these shorter time period, deep in the money calls.
Calculating The Return for Deep In The Money Calls
Below are the call premiums for January 2012 as of Oct 7 2011. Beside each strike I write the return I can expect if the trade works out and I am exercised from the stock with the January options expiry. I then list the cost basis or break even of the stock should XOM stock fall below the deep in the money calls sold and they end up expiring out of the money.
XOM Stock also pays a dividend of .47 cents in November. This will add to the above returns and lower the cost basis in the stock.
Deep In The Money Calls – Determine The Proper Call Strike To Sell
With the above information I then chart out the stock from the last 3 years. Below is XOM Stock history chart from Oct 2008 to Oct 2011. This makes my decision of what deep in the money calls strike to sell straight forward. $68.03 is the low of this year. $64.50 is the low from 2009 and into 2010. $61.50 was the low seen in the 2010 correction before QE2 was underway. $59.50 marks lower lows of 2010.
At these levels, I can also consider the dividend yield. For example at $68.03 and an annual dividend of $1.88 the return is 2.7%, but at $59.50 the dividend yield would be 3.15%.
I take the above 3 year chart valuations and compare them to the deep in the money calls strikes to determine the amount of risk versus profit I am willing to accept. On the XOM Stock option chart below I have marked the 3 year chart valuations in purple.
Looking at the 3 year historic chart and then the deep in the money calls strikes I probably would pick the January $65.00 call to sell. It provides a 3% return and it is in the middle of the 4 valuations from the past 3 years.
If I capture the November dividend payment of .47 cents my total return if exercised in January would be 3.78% and should XOM Stock fall below $65 by January options expiry, my cost basis would be $63.01 less .47 dividend for a cost basis of $$62.54. Select this deep in the money calls link to view the present values of XOM Stock Options. You can use the present option values to calculate possible option premium valuations at varying stock values.
Being Realistic With Deep In The Money Calls Strikes
So how realistic is it to pick the $65 deep in the money calls? Investing as far as I am concerned is not gambling and as a result I like to look at how realistic my deep in the money calls are. I picked $65.00 and if the stock should crash my cost basis is $63.01, but what situation would I find myself in should XOM Stock collapse?
No matter how long I have invested, a market crash is still terrifying. When investors dump shares the buyers run away and share values plunge. It’s incredible to watch. When selling deep in the money calls I have placed my capital at risk and there is nothing more gut wrenching than watching my stock collapse and plunge below my break even on a deep in the money calls position.
To help me sleep nights, I turn to history. The most recent market crash was in March 2009, but the price of XOM Stock actually crashed in the October 2008 market crash. Below is the October 2008 XOM Stock chart. On Oct 10 the stock hit 56.51, the low of the 2007 – 2009 bear market.
Two things are important in this chart. The first is that at $63.01 my break even does appear to be a very good valuation. I have marked it in blue below. Even during the October 2008 crash, the stock bounced right back above that value. This means I would have a good chance to unload my shares or sel covered calls.
The second is that at $56.51 there would be call premiums available at $65.00 for around .45 cents two months out. Based on normal volatility XOM Stock has a volatility on average of 24. That would give the $62.50 call strike a premium of about $1.00. In the event of a crash these premiums would be higher.
Going out 6 months the $62.50 call would have a premium of $2.90 while the 6 month $55.00 call would have a premium of around $6.50. $6.50 added to $55.00 = $61.50, just $1.51 shy of my break even. Meanwhile 6 months would provide two more dividend payments of .47 cents each or .94 cents. This would place my loss at just .57 cents.
If though the stock fell lower than $55.oo by the time the 6 months options expire, my cost basis in XOM Stock would be reduced from $63.01 to $55.57. Not a bad place to be on XOM Stock.
Deep In The Money Calls – Summary of XOM Stock Trade
If the above deep in the money calls work and I am exercised from XOM Stock I have the potential to earn a total return of 3.78% for 4 months. If this deep in the money calls trade could be repeated twice more during the next 8 months the realized return would be 11.34% for the year. Not too bad a return considering the level of protection the deep in the money calls have provided.
Meanwhile I know in advance what I would do with my present deep in the money calls, in the event there is a market collapse and the valuations of XOM Stock plunge past my break even of $63.01.
Deep In The Money Calls Will Not Make You Rich
It’s important to remember that you are never going to rich using Deep In The Money Calls. This is not a strategy that will make big profits. As soon as the deep in the money calls are sold, you have locked in your immediate profit. This is a strategy to assist investors who want to gain some income as well as possibly pick up a great stock at a very reasonable price.
Put Selling and Deep In The Money Calls Have Similar Goals
My concept behind put selling is to earn income while waiting for a stock to reach a level I would own the stock at. In the interim by put selling I am being paid to wait for the stock to fall as well as earn capital which I can use towards the eventual assignment of shares in the stock I have sold puts against.
Deep in the money calls has many of the same characteristics as put selling. I am looking to protect my stock and thereby my capital by selling deep int he money calls. I am earning a small premium by staying in the market and I may end up owning a stock at what at the time at least, seemed like very good value.
Having An Advance Plan Is A Priority When Selling Deep In The Money Calls
It’s important to realize that staying in a bear market has a lost of risk involved. Bear markets are nasty and no matter how terrific the stock, a bear market can decimate a stock’s value. However by selling deep in the money calls I am protecting my position while at the same time setting myself up at stock prices which I would be comfortable holding shares at and selling covered calls against. If however the stock falls further than my break-even, the importance of having a plan in place IN ADVANCE is paramount to the success of selling deep in the money calls.
Deep In The Money Calls Can Only Provide Limited Protection In Bear Markets
Deep in the money calls no matter how great the level of protection, have a limit to that protection. In bear markets stocks overshoot to both the downside and upside. Never lose sight of the importance of protecting your capital. Your capital is your lifeblood for future growth and investing. It’s loss can severely hurt future prospects for your overall portfolio. This is why for those investors who are concerned in bear markets, stepping aside and staying in cash is never a mistake.
Deep In The Money Calls Have Other Considerations
There are other things to consider when getting involved in deep in the money calls as a strategy for use in a bear market. I will discuss these as I look at a few other stocks and present the tools I use to assist timing when to roll my deep in the money calls, deeper and when to roll them back up. I will present a couple of stocks from the 2008 to 2009 market crash and show how the deep in the money calls worked to protect my long-term RRSP stock holdings and when and how I determined the appropriate time to roll my deep in the money calls, higher up.