Stock market volatility tends to increase into the seasonality weakness period from late summer to early fall. It may be appropriate to hedge an investment or trading stock portfolio during this period.
The CBOE Volatility Index (VIX – 15.85) has rallied sharply in recent weeks from a recent low of 12.73/12.74 (Jun/Jul 2023) toward a high of 18.14 (8/8/23). The fear indicator appears headed toward a volatile and choppy trading range between 12.73-12.74 and 19-21 (200-day and May 2023 highs) into August to early September. The VIX Index trading range can translate into an SPX trading range between 4,100-4,200 and 4,600-4,700.
In a volatile sideways trading range market, covered calls may be an alternative strategy to insure against potential losses in a stock portfolio. However, this defensive options strategy will limit upside potentials but can generate income by collecting premiums.
A covered-call trade allows a trader to sell a call option on an asset. The strategy gives the buyer the right, not the obligation, to purchase the asset at a specific strike price on or before a certain date.
When the price of the asset decline but does not reach the strike price before expiration, the call option expires worthless as the buyer walks away from the trade. However, the investor will collect the premium as their compensation.
On the other hand, when the price of the asset rises above the strike price, the option buyer has the right to purchase the underlying asset at that price. Investors keep the premium as income but can miss out on additional gains on the stock unless they buy back the option at a loss.
The higher volatility results in higher options premiums, offering income investors and traders a favorable defensive strategy to implement during choppy and trading range markets. The trade was profitable during 2020/2021 and again during last year (2022) into the bear market decline.
In 2023, cover-write strategies lagged significantly behind the stock market returns due to the FOMO rally in mega-cap technology stocks. Although stocks tend to trend higher over the longer term, a covered-call strategy can still be effective during challenging markets by providing protection and income while the market consolidates.
Covered-call strategies tend to be implemented by sophisticated options traders and professional money managers. However, retail investors have turned to Exchange Traded Funds (ETFs), including covered-call ETFs, to improve their investment/trading strategies.
Popular covered-call ETFs include JPMorgan Equity Premium Income ETF (JEPI – 55.43 and a yield of 10.05%), Global X Nasdaq 100 Covered Call ETF (QYLD – 17.78 and a yield of 11.47%), and Global X S&P 500 Covered Call ETF (XYLD – 40.93 and a yield of 11.04%).
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