4 Rules for Generating Profits During Market Declines

Writing covered calls is a popular and generally conservative strategy that many investors use to generate a consistent stream of income from their portfolios. In a nutshell, an investor who owns 100 shares of an optionable stock may elect to sell someone else the right to buy those shares from the investor at a certain price (strike price) by a certain date (expiration date).

While the strategy typically works best with stocks that are flat or trending slightly higher, covered call writing is a flexible enough strategy that it can be profitable under most market conditions. And that includes bear markets, too. Remember that in volatile markets, increased volatility equals increased premium income.

Still, you will need to take certain precautions to be successful writing covered calls during a bear market. Here are 4 rules for doing so.

1)Write In-The-Money Calls Only

Writing in-the-money calls is a good idea in any market, but it's essential when the market is falling. Writing a call at a strike price below the current share price may reduce your income potential and prevent you from participating in any capital gains if the stock moves higher, but it will give you much greater downside protection than if you write the call at-the-money (roughly equal to the current share price) or out-of-the-money (at a strike price higher than the current share price). Added protection is essential during bear markets.

2) Be Extra Diligent In Your Trade Selection

When everything is rosy and the stock market does nothing but chug a little higher every day, trade selection for covered calls may not be that crucial. In the good times, you can sometimes get by without doing your homework. But you simply can't afford to wing it during a bear market. It's essential that you only write covered calls on technically and fundamentally sound companies.

3) Add a Protective Put To Your Covered Call Position

I know of one covered call subscription service that promotes a customized strategy involving the purchase of a longer-term put to be used in conjunction with the covered call position. The advantages of the longer-term put is that it can provide multiple months' protection, and it also retain its value better than a short term put (the time value of a longer term option decays much more slowly than that of near term options).

4) Be Patient And Flexible

Sometimes the best course of action is to do nothing. A bear market is one thing, but a complete market meltdown is something else. In the market mayhem of October 2008, when the Dow experienced its first ever 1000 point intraday swing, the best trade for covered call writers was to be on the sidelines. You can make money writing covered calls in choppy waters, but in case of a hurricane, you definitely want to be inland. There is no rule that says you must always have an open position. Many conservative call writers, for example, won't even consider writing a call on a stock that's trading below its 50 day moving average.

Writing covered calls during bear markets can be a viable strategy for income and profits, provided you do your homework and take proper precautions.