Covered call strategies are popular with options sellers due to their capacity to generate regular income over time. In markets that rise or trade sideways, the call option premium supplies the income, and in falling markets, this same premium offsets the losses. Investors have used covered calls for more than 30 years. Theyre so popular that in 2002 the Chicago Board Options Exchange released the first major benchmark index for covered call strategies the CBOE S&P 500 BuyWrite Index (code BXM).

To make the best returns from covered calls, its generally necessary to apply them to stocks and shares with a much higher historical volatility. Although this appears somewhat counterintuitive, research has revealed and even Warren Buffett has commented that there is no correlation between beta and risk. The key reason why these volatile stocks can be so appealing is that theyre able to return 40%+ per annum not necessarily because the stock price is going to rise dramatically but because the inflated option prices reflect the expectations for underlying stock volatility.

But covered call strategies also carry a measure of risk so we need to apply the right approach to different market conditions. The worst case scenario is when you purchase a stock, write out-of-the-money covered calls above the purchase price and then the same stock price takes a big dive soon after. In cases like this, the option premium you have just received will probably not cover the capital loss on the shares themselves.

So what can you do?

Your original sold OTM calls will be significantly devalued by now, so you could buy them back for a song and then sell more at a lower strike price. This would bring in further premium to offset the capital loss on the shares. But if youre relying on covered call strategies for a regular income you wont be making anything on those shares this month and if the price continues to decline, you may even have to take a loss.

So while writing OTM covered calls is great for a sideways or bullish outlook for a given share, it may not be the best idea when they are near their price peaks. You could purchase protective OTM puts at strike prices below the share purchase price but this would lower your overall income. Protective puts are a better strategy if youre more investor than trader minded and plan to hold the shares for some time.

Nevertheless, in a bullish trend, OTM covered calls give the best outcome you receive option premium plus a capital gain on the shares themselves. But for this strategy to work, you should use the best research tools to increase the probability of success. In this regard, the Investors Business Daily online Power Tools can give you the Top 20 US companies by Earnings Per Share. Add to that their own 12 month Relative Strength Ranking and with these two fundamental indicators you can be assured of much greater confidence that your chosen stock will continue to rise.

What About a Bear Market?

If the market as a whole has turned bearish, you can still make a regular income with the right covered call strategies. In this case, the best alternative is to sell IN-the-money call options over your shares. The intrinsic value in your sold call options will work in your favour should the underlying price fall. If these options become OUT-of-the-money you will be able to buy them back for a much cheaper price than you sold them for, thus making a profit. In the meantime the extra premium you have received will provide a much greater buffer against falling share prices than out-of-the-money premiums.

Once the share price has fallen significantly (but not as low as your ITM call option strike price) you buy to close the sold options and immediately sell MORE in-the-money calls at a still lower strike price. The profits you make under these conditions are from the time value of the options, which if prices have become volatile may also include some decent implied volatility to increase your returns.

And Sideways Markets

If youve observed a share price which is stuck in a narrow range and unlikely to move much either way in the short term, its very likely that option prices will be cheaper due to low implied volatility. This will reduce your income, which is what you exchange for lower perceived risk. For stocks like these you should consider writing AT-the-money call options over the stock. You will receive more premium than for OTM calls and since the stock price isnt really going anywhere, you just rinse and repeat each month until things change.

You can search for these type of stocks using a good stock and options screener, which most reputable brokers include with your account.

Making consistent returns from covered call strategies is simply a matter of deciding what risks and returns youre comfortable with and then applying the appropriate method.

Owen has traded options for many years and writes for Options Trading Mastery, a popular site about the best Option Trading Strategies. Discover a wealth of information about options, including the popular Covered Calls