Option Investor

Covered-Calls 101

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Position Management

A few weeks ago, we discussed some potential adjustments for the conservative position in American Airlines (NYSE:AMR). Today the stock traded at a long-term high near $32, thus there may be an opportunity to lock-in some profits. Let's review the original trade and the adjusted position then we'll take a look at the current situation.

Here's the chart and the data for the original recommendation:

Long AMR stock at $27.70
Short NOV-$25.00 Calls @ $3.20
Cost Basis = $24.50
Maximum ROI = 2.0%

The trend was moderately bullish when we offered AMR as a covered-call candidate however the stock's upside potential was somewhat limited by a previous resistance area near $29. A few days after the play was initiated, the buying pressure declined and the stock appeared to be headed back to the middle of the multi-month trading range.

Most traders would likely have waited for the issue to test the near-term technical support level near $25 before taking action. But, in the interest of education, we offered two possible alternatives for defensive adjustments; one using front-month (DEC) options at the $22.50 strike and a very conservative trade involving JAN-07 options at the $20.00 strike. The roll-out to December options provided a reasonable balance between reduced risk and acceptable reward, based on the resultant position:

Long AMR stock at $27.30
Short DEC-$22.50 Calls @ $5.40
Cost Basis = $21.90
Maximum ROI = 2.7%

Of course, Murphy's Law eventually intervened with the stock soaring unexpectedly to levels not seen since 2001.

Now there is a new dilemma...should you:

1) Take the existing profits?

2) Wait until the options expire in December (and hope the stock price remains above $22.50)?

3) Roll up and/or out to benefit from a continued rally?

If you buy the sold calls at the current price (roughly $10.10) and sell the stock for $32.30, the gain will be approximately $0.30 per share, less commission costs. If you decide to wait (four weeks) until the December expiration date, the credit will increase to about $0.50 per share, less commission costs, as long as AMR does not retreat below the sold call strike. Obviously, the outcome will be significantly affected by the number of shares/contracts involved and the cost of each transaction (including slippage) so it important to calculate the results before making a final decision.

Another thing to keep in mind is the possibility of an unexpected assignment when the sold calls are in-the-money. Indeed, those who want to retain their AMR shares should understand that the risk of early exercise increases substantially when the options are bid near parity (no extrinsic value). However, as long as there is some "premium" left in the price of the options, there is less risk of early assignment and you can benefit from additional time-value decay by staying with the original position. Once the option trades at parity, there is an increased probability of exercise by arbitrageurs; floor traders who don't pay commissions.

Since the options have only $0.20 of extrinsic value, investors who want to hold on to their shares and sell additional calls should probably do so in the near future. A new cost basis in the stock will be established based on the realized credit (or debit) from the transaction. If you are extremely bullish, you can roll up, selling new calls at a higher strike to increase the profit potential. The problem is that you give up downside protection due to the debit incurred in the transaction. The adjustment becomes more aggressive (and less favorable) as this outlay increases because you are putting additional capital - from a previously profitable position - in jeopardy. A more defensive move would be to roll both up and out to a distant strike price, thus achieving a better balance between risk and reward. Consider the possible outcomes of a transition to the JAN-$30.00 calls:

Buy DEC-$22.50 Calls @ $10.10
Sell JAN-$30.00 Calls @ $4.10
Cost Basis in AMR stock = $27.90
Maximum ROI = 7.5%

In this situation, the maximum return on investment is achieved even with a decline of over $2 per share and the stock price would have to drop $4.40 (13%) before there is a draw-down in the new position. Nevertheless, the strategy of writing covered-calls will only limit losses in a bearish market, not prevent them. If the underlying issue reverses sharply to the downside, it may be best to simply exit the trade and look for another covered-call candidate.

Before you make a final decision, it is critical 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, investors who remain adaptable and creative will generally have greater long-term success with this strategy. Despite what many people think, you are not locked-in to only one or two alternatives. You can always diversify by spreading the sold calls over time, as well as different strike prices, and this type of flexibility will allow you to maintain an assortment of positions with varying costs, smoothing your portfolio balance through unfavorable market cycles.

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