The market just closed, and the Dow rallied back from a huge deficit this afternoon.
Make no mistake.
Selling pressure has returned in droves.
Since last Thursday, it’s appeared that negative momentum is grabbing hold.
And this could be the start of a short-term pullback that extends a few sessions and up to 10%.
I’m watching capital flow out of Big Tech. The Fed is reducing its buying. And volumes are getting lighter despite higher prices.
This isn’t the end of the world.
Sell-offs in the stock market are normal. It is never-ending rallies that are not so normal.
So, what’s the remedy for a short-term downturn?
Well, it’s a good time to do… this.
We have discussed strategies to protect our cash from a big selloff in the market.
All of the profit protection schemes we discussed will help you sidestep the big one that causes crushing losses.
We’re going to see short term pullbacks in the stock market from time to time.
When this happens, it’s best to do nothing with our long term stock portfolio.
If the market is still above the 200-day moving average and the dual momentum signal is always positive, we don’t need to sell our solid long term holdings.
However, it might be a good time to sell a covered call on some of our stronger stocks.
As a refresher, when we sell a covered call, we are selling someone else the right to buy our stock at a specified price (the Strike Price) for a certain period.
The cash we get paid for agreeing to sell is called a “premium.”
If the stock goes beyond the strike price, the option buyer will exercise his option and buy the stock at the agreed price. We get to keep the premium we collected.
If the stock does not go above the strike price, the option will expire worthless, and we keep the premium.
So, we get paid either way.
Why Covered Calls
When I see stocks get to high Relative Strength Index (RSI) readings, I like to bring covered calls into play as a method of collecting cash on stocks that may have run too far too fast.
As we have discussed earlier, 14-day RSI Readings over 70 are considered overbought, and the stock may be setting up for a decline. Readings below 30 indicate that the stock may be oversold, and it’s time to look for buy signals.
When I see stocks that have extreme RSI reading above 80, I know that there is a good chance this stock will see a correction.
That gives me an opportunity to collect some cash by selling covered calls. If the stock does correct from the extreme overbought level, I keep the cash and the stock.
If it doesn’t, I still keep the cash. I can also buy the stock back and sell more calls.
Making Money on the Pull Back
You don’t have to wait for the calls to expire to collect the cash. If your stock drops after you sell the call, you can buy back the option at a profit to close out the trade. This is a good idea if the stock drops and begins to consolidate and look like it is going to give a short term buy signal.
If the stock rallies back up to oversold levels, you can sell more calls to collect more cash.
Only sell as many calls as you own shares of the stock. Each call represents 100 shares of
stock. If you own 100 shares, then you can sell one call.
But do me a favor and yourself one. Don’t sell calls if you’re a beginner and you don’t own the stock.
Being short of an uncovered or “naked” call can be a disaster in the making.
There are horror stories about people who sold uncovered calls to collect cash. If there is a takeover offer or other event that drives the stock a lot higher very quickly, you will be scrambling to buy back stock to deliver to the call owner.
Houses have been lost by selling uncovered calls.
Don’t do that, especially as part of a longer-term portfolio strategy.
Covered calls are a tool for improving total returns and lessening the pain of a short-term pullback. Like all tools, there is a time and a place to use this strategy.
I like to sell calls when stocks have reached extreme RSI levels that tell me a pullback is likely.
It’s more effective if the market has also been rising for a while and has high RSI levels.
If you look at the chart of the S&P 500, you can see that the RSI levels have moved to extreme readings above 80 recently.
So, now is the time to act.
Enjoy your weekend,