Option Investor

Covered-Calls 101

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Q&A on Position Management

To: Covered-calls Editor

I started reading your covered calls newsletter a few months ago and even though I'm new to options, I did very well with the first few trades. Then the market dived and I started losing money -- I didn't get out when I should have. Now I'm trying to figure out how to cut my losses when things go wrong. Do you have any suggestions for the best way to get out of the trade such as when to sell the stock and whether to let the option ride or buy it back? Also, what can I do with the stocks I have that have tanked with the market? I looked at selling more options a couple months out but they aren't worth much -- have I waited too long? Any help would be appreciated.


Regarding Covered-Calls:

When a trader writes (sells) a call against shares of stock he or she already owns, the position is "covered," hence the name: covered-call. If the stock price is above the sold option's strike price at expiration, the option will be exercised and the stock will be "called" away. If the stock price is below the strike price at expiration, the sold call will expire worthless and the trader will keep the stock (as well as the cash received from the sold call).

An investor who wants to earn consistent income through stock ownership might use the "in-the-money" approach to covered-writing. The goal of this technique is to achieve acceptable returns while maintaining an above-average amount of downside protection for the underlying stock. Despite the "conservative" classification generally associated with this strategy, it is susceptible to losses and prudent money management suggests the use of a mechanical stop-loss order on the combined position (or on the underlying issue) to limit potential draw-downs. Some common stop-loss signals an investor might employ include: a percentage of the cost of the position, a specific portion of the overall portfolio value, or a violation (by the stock) of a technical support level such as a moving average or trend-line.

Once you have decided to close a covered-call position, you must repurchase the calls and then sell the stock. A simultaneous "net" order can also be used in closing a covered-write to ensure an efficient exit. In this case, you would place an order with your broker to sell the stock and buy the calls for a specified net credit. This amount should be slightly more than the composite total of the BID and ASK prices. For example, if the current ASK price of the call options was $0.25 per contract and the stock was BID at $12.25 per share, a net (position closing) credit of $12.10 might be appropriate. If this order was filled, it would produce a surplus of $0.10 per share/contract over the market price ($12.25 - $0.25 = $12.00 versus $12.10).

It's no secret that the recent stock market sell-off provided numerous opportunities to manage covered-call positions and the best that can be said for the event is many investors gained valuable experience in the process. For those who did not, a theoretical situation follows:

In June, you bought XYZ stock at $13.88 per share and sold XYZ JUL-$12.50 calls for $2.00 per contract. Your cost basis (or break-even point) was $11.88 per share less commission costs. When the equity markets began to slump, your stock slipped to $11.50 - below an established technical support area - and you decided to close the position to preserve trading capital. The following day, you were able to buy back the calls for $0.45 per contract and sell the stock at $11.45 per share, incurring a loss of $0.88 per share.

The math is fairly simple:

$11.88 - $11.45 = $0.43 + $0.45 (cost of calls) = $0.88 debit (not including commissions).

A loss has occurred and even though the strategy of selling in-the-money covered-calls on bullish stocks is a relatively conservative technique, occasionally you will be faced with a stock that declines sharply after it is purchased. If you believe the issue will eventually recover, one of the most common methods for limiting potential losses is known as "rolling-out" and it is typically initiated when the underlying issue falls to (or slightly below) the strike price of the sold option. Since you are being defensive and trying to lower your cost basis in the covered-call position, you would roll the sold options down (in strike price) and/or forward to a distant month. If this adjustment is done prior to the option expiration date, it will be necessary to buy back the current sold (short) calls. Again, to roll down, you sell a lower strike call and to roll forward, you move to a future expiration month. Only a person who is bullish on the stock in the long-term will do this (to protect against short-term weakness) because ultimately, he expects the stock to recover. In some instances, you will have to move forward several months (or use LEAPS) in order to obtain a credit in the new position. If the stock price has dropped substantially, it may be that the best available result is to lock-in a small loss, which would still be less than the current (large) loss, providing the share value doesn't drop further.

Using the roll-out with the previous example...

After buying back the sold calls, your new cost basis ($11.88 + $0.45) is $12.33. You evaluate the stock's technical and fundamental condition and decide the share value will rebound at some point in the near future. You feel the stock may drop to around $10.00 but ultimately will return to a bullish trend. With this assessment in mind, you decide to roll down and forward to the XYZ OCT-$10.00 strike, which is selling for $3.15 per contract. The adjusted position offers a new cost basis of $9.18 ($12.33 - $3.15 = $9.18 less commissions), which provides additional downside protection while also offering a reasonable return on investment at the expense of tying up portfolio capital for a longer period of time.

One important fact about most adjustment techniques is you can't wait until the stock is well below the sold option's strike price before taking action. The longer you wait, the further you will need to move into the future to achieve a lower cost basis. Experienced traders try to make the transition when they can roll to next expiration period, so they can sell the highest relative premium for a small credit and not commit to a long-term position. Obviously, you will need to sell large amounts of time value to offset more severe declines in the stock price however investors should be cautious when using this technique on all but the most high quality issues as you can quickly run out of downside margin when the stock price falls further. When the stock has moved well below the sold strike price, this technique is not viable (you have waited too long to act) and another form of loss control is necessary.

As with most forms of trading, the ability to control losses is paramount to a successful portfolio. Stop-loss orders are an essential part of this process and basic technical analysis can be used to identify areas of support or resistance, which help determine the correct exit and/or adjustment points for each position. Stan Weinstein's book: "Secrets for Profiting in Bull and Bear Markets," provides a basic explanation of the use of technical analysis in evaluating stocks. In addition, Larry McMillan's book, "Options as a Strategic Investment" includes some excellent information on position management with covered-calls. Both of these publications are available in the OIN bookstore.

Good Luck!

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