Options are an excellent tool for the difficult trading days we saw last week. Experienced options trading investors rarely sell into a panic because they know it will end and the market will once again value stocks fairly. Rather than selling stocks, these investors take some kind of protective action such as selling covered calls to capture time premium while the premiums are high.

How To Handle A Market Meltdown

The price of options rise during times of high uncertainty. This can be a good thing if you are a seller of premium (which covered call writers are). However, you probably don’t want to sell strikes below your break even point unless they are very short term. A better plan might be to lock in a few months of premium while anxiety is high.

Let’s take two examples: An existing position where the stock has dropped below your break-even point, and a new position that you’d like to initiate during the market meltdown.

Trading Idea 1 – Existing Position

Let’s say you bought XYZ Corp at $100 a few weeks ago and sold a March 105 call option for $2 (so your break even is $98). Today, after uncertainty in the Middle East and Japan, you find the stock is now trading 15% lower at $85/share, and the Mar 105 call is trading for 10 cents. Let’s say its Wednesday on expiration week.

This is a good candidate for rolling down for the March cycle. You can buy back the Mar 105 call option for 10 cents and then sell a Mar 95 call option for maybe 50 cents. You get a net credit of 40 cents so your break even is now $97.60. You are at risk of having the stock rise by more than $10/share in the final days two of the March cycle and having it called away, but that seems unlikely (12% rise in two days). If it happens then you will receive $95 for a stock that you have a basis of $97.60 in. Bottom line, you could lose $2.60/share if called.

Find more option analysis and trading ideas at Option Trading Strategies.

On the other hand, if the stock stays below $95 by the March expiration then next Monday you can sell a new option for the April or May expiration. You may want to do the Apr 95s or May 95s, whichever one will give you at least $2.60/share in premium, so that your break even will be less than $95 and you will make something if the stock is called. You may not make a ton but we are talking about a market meltdown situation here, so making anything at all will be a win.

Go to page two for Mike’s second approach to using covered calls during a large sell off.

Trading Idea 2 – New Positions

After several days of triple digit drops in the DJIA, it could be a good time for options trading investors to put on some new positions and write calls against those positions. If the uncertainty of Japan worries you then sell in-the-money calls against your newly purchased stock. You will have some extra downside protection, and the premiums can be quite good during periods of high anxiety.

An example of a good company that got hammered last week is Apple (NASDAQ: AAPL). It was down 5% on Wednesday on a combination of an analyst downgrade and concerns over supply of Japanese parts for its products. But Apple is a well run company, it will figure out how and where to manufacture its products, and the recent tragedy isn’t going to change the fact that there is huge demand for their products. If they can build them then they will sell them.

AAPL closed Wednesday at $330. You can sell an Apr 315 for $24.30, bringing your net debit (break even) to $305.70. That means if AAPL is over $305.70 by Apr 16 then you make money. AAPL would have to drop by another 24 points (7.3%) in 29 days to make this a losing trade. And if AAPL is over 315 and gets called away then you make 3% in 29 days, or an annualized rate of return of 38%.

Don’t Panic

Selling premium during a panic is a reasonable alternative to selling your long stock positions, especially if you have large unrealized gains on those stock positions in a taxable account (where selling will create a tax event). If you don’t want to cap your upside by selling calls then perhaps buy some puts instead. They will probably be expensive, but at least you can sleep at night and not worry what happens if Japan’s meltdown gets worse overnight.

Mike Scanlin operates Born To Sell, a web site dedicated to helping people earn monthly income from selling call options.