I get this above question frequently when I share about how the drop in share prices generates higher returns for the covered call contracts that I sold.
Why I Choose To Roll My CALL Option Contract When Share Price Falls
It is true that when the share price of a stock falls, the stock also loses its value. However, it is a paper loss and not an actual loss, unless you try to sell them away and realize the loss.
For fundamentally strong companies, there is every possibility that the share price will drop due to the macro environment influence or earnings falling below expectations in some quarters.
However, it does not mean that the stock will continue falling forever. Over a long period of time, the paper losses will be gone and you may even end up with a paper gain.
Let’s take a look at Apple’s share price for the past year.
It started at around USD133.48 one year ago. Despite being the most valuable company in the world, it rises and falls (see yellow circle), rises and falls again and keeps repeating the gains and losses, and eventually ends up higher at USD163.64. So, a share price falling does not mean it will fall forever, it will eventually rise up again after going through a correction.
Missed Opportunities
If you sit there and do nothing, you miss out on the potential to earn extra gains through collecting premiums from selling covered call contracts over the months of waiting for the stock to recover.
With these returns from selling covered call contracts, you will be able to lower your breakeven price, which means you will reach a breakeven state (zero paper loss) faster.
So, when the whole market is going through a downturn or selloff, selling covered call contracts is a good strategy to generate some returns for you while you wait for your stock to recover.
Using the same example above, the yellow circles are the periods where you can profit off selling covered CALL contracts and earn some decent premiums.
To maximize your returns from selling covered CALL contracts, check out this method of rolling covered CALL contracts when the share price drops:
I Discovered A Way To Generate Higher Returns From Selling Covered CALL For Low IV Stocks Like Apple
Is there a better way to profit when the share price drops?
There are other ways to profit when a stock or when the whole market is on a downtrend. Assuming you do not own enough shares to sell covered CALL contracts, you can either buy PUT option contracts or short the stock.
Buying PUT contract
Buying a PUT option contract allows you to lock in the selling price upon expiration, which is also the strike price of the contract. Thus, if the share price keeps falling, you will earn a bigger profit on your strike price and thus premium of the contract will increase. You can then sell off your contract and pocket the gain in premium.
Shorting selling the stock
Short selling involves you selling at a certain price and then buying the stock back at a lower price to cover back your short position. Let’s say you think Apple stock price will fall due to a certain strong reason. So, you start the short contract by selling Apple at USD163 and when Apple’s share price starts to fall, you buy it back at a lower price, say USD143, and earn a profit of USD20 per share.
What if you get it wrong?
If you get it wrong for buying a PUT contract, which means the share price starts rising or spiking up after you bought your PUT contract, then your max loss is the total premium you paid for the contract. It happens when the contract expires worthless, as the underlying share price is higher than the strike price of the contract.
If you get it wrong for the short contract, the loss is unlimited as you need to buy back the share at whatever market price to cover back your short position. Say you sold Apple at USD163 and it spikes to USD363, you lose USD200 per share.
Read more about the possible dangers of trading here:
Understanding The Risk Of Margins, Selling Naked CALL & PUTS
Why Covered CALL is still the best strategy for me?
If I get the prediction right and that the market is indeed going downwards, I will profit from selling and rolling my covered CALL positions. If I get it wrong and the market rises instead of falls, I will sell at the strike price that I am comfortable selling and release the capital that I can use for other trades. Thus, it is a win-win situation.
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