Option Investor

Covered-Calls 101

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Position Management Strategies

One of the fundamental skills of successful covered-call writers is effective position management. Despite the conservative character inherent in the strategy, stocks that do not move as expected often require timely exit and adjustment trades to lock-in gains or limit losses. This necessity can arise with both bullish and bearish issues, depending on the objectives of the original position. Today we will review some common techniques for maximizing upside potential with "in-the-money" covered-calls.

Many of our readers utilize a momentum-based approach when choosing covered-call plays. The goal of this method is to identify trending stocks and write out-of-the-money options to provide some amount of downside protection while allowing for additional capital gain. In those instances where the directional forecast is correct, stock ownership beyond the original (option) expiration date may become necessary in order to take advantage of future bullish activity. In contrast, some positions may warrant an early exit due to the potential return generated by a sharp upside movement in the underlying issue. The key point in both of these scenarios is that a trader does not have to wait for an in-the-money option to be assigned at expiration in order to realize a profit.

Consider a few of the picks made in the CCS portfolio in early January. Stocks such as AEM, AIRM, BGC, GG, OS, and SPWR have made substantial gains and all of these positions are expected to be assigned in two weeks. However, some issues may warrant continued ownership, based on their recent performance. In fact, there are several alternatives when the underlying stock moves above the sold (option) strike price in a covered-call position. The trader can:

1) Do nothing, wait to be "called out" and accept the original return on investment that was established when the position was initiated.

2) Close (buyback) the short options early and sell the stock for a smaller overall gain. This action is generally best when the price of call is near parity because the closing debit is minimal and the reduced time-frame helps outweigh the extra commission costs.

3) Roll the call forward (or forward and up) in order to increase the maximum potential profit in the position. A new cost basis is also established, depending on the realized credit (or debit) from the transaction.

Of course, anyone who intends to roll the sold options in a covered-call play should be aware of the potential for early assignment when the strike price is "in-the-money." This risk is most significant when the options are bid near parity (no extrinsic value). With deep-in-the-money calls, the time value can disappear well before expiration, so it is critical to monitor these plays on a daily basis. As long as there is some premium left in the calls, there is little risk of early assignment (and you can benefit from additional time-value decay by staying with the original position). Once the option trades near parity, there is a significant probability of exercise by arbitrageurs; floor traders who don't pay commissions. Investors who want to retain their stock but have yet to make an adjustment should do so immediately. The steps in the process are relatively simple:

1. Repurchase the sold calls; then write longer-term calls with the same or different strike price, depending on your outlook for the underlying issue.

a) If you are bullish, you can roll up, selling new calls at a higher strike, thus increasing the profit potential. The catch (there is always a catch!) is that you may give up downside protection. When one rolls up, a debit is often incurred and this can be viewed as unfavorable because you are putting additional money at risk in a previously profitable position.

b) A more defensive move would be to roll to the same strike or occasionally, down to a lower strike, in expectation of a lateral or declining share value. For conservative traders, this approach may offer the best balance between profit potential and downside protection. Keep in mind, the strategy of writing covered-calls will only limit losses, not prevent them. If you become bearish on the underlying issue, it may be wise to simply sell the stock and search for a new position.

Before you make a final decision, it is important to evaluate the risk-reward outlook of each scenario and choose the alternative that best fits your expectations for the future movement of the underlying issue. In addition, those who choose to initiate an exit or adjustment trade prior to expiration should consider using a "net-credit" order to ensure an effective transition to the new position. This involves repurchasing the sold calls and simultaneously selling the stock or new options and it can considerably reduce slippage; losses from multiple (untimely) trades that often occur when managing combination positions.

One last thought, Larry McMillan's most recent publication; New Insights on Covered Call Writing, does an excellent job explaining the various adjustment strategies used with covered-call positions. This title is available in the OptionInvestor.com bookstore and it is well worth reading, regardless of your experience level.

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