Option Investor
Educational Article

Back To The Basics

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The simplest and safest option trading strategy is that of the Covered Call, yet it continues to amaze me how often I speak with traders that have failed to capitalize on this cash-generation tool in their portfolios. Every weekend, Mark Wnetrzak writes a great column highlighting attractive covered call trades, focusing on the strategy of buying stock and then selling a covered call on that stock to generate a steady monthly income.

Without stepping on Mark's toes, I want to focus on the use of this strategy for those traders that are still holding onto stocks that are significantly under water. For whatever reason, you didn't sell the stock at a higher level, and don't want to take the loss at today's depressed prices. We need to keep in mind that the simple strategy of selling covered calls can start us on the path to recovery by reducing our cost basis in a depressed stock.

I know there are always new traders that are unfamiliar with some of the strategies we talk about here. Rather than re-invent the wheel, let me encourage you to review some of Mark's Covered Call Basics articles, which can be found by clicking on the Covered Calls link under the Strategies header on the OIN main page. The basic strategy employed in that column is to buy stock and sell a covered call with the eventual goal of having the stock called away for a profit. What I want to talk about here is a slightly different approach. Assume you have 1000 shares of CSCO, with a cost basis of $20 per share, and you have watched in frustration as the stock has continued to post a series of lower highs over the past 9 months, reaching down near the $11 level again yesterday. Don't despair, as there is a method to get you back near break even, regardless of whether CSCO in fact approaches that level over the next year or so.

All we have to do is take advantage of each rally to sell a front-month call with a strike slightly higher than the nearest resistance that we expect to hold through the end of the current expiration cycle. I know that is a mouthful, but I think we can best illustrate the concept with a detailed example. Just remember this one fine point of the strategy -- we DO NOT want to have the underlying stock called away, because that will result in locking in the loss that we are busily trying to mitigate.

Let's go ahead and use the CSCO example we started with, assuming we have 1000 shares with a cost basis of $20. With the stock currently sitting just below $12, we are sitting on a 40% paper loss. Let's look back at the past few months and show how we could have steadily reduced that loss.

Each time price action topped out near resistance in combination with the daily Stochastics rolling over from overbought, we could have taken that opportunity to sell a call with roughly one month until expiration. Shorter-term calls would have worked as well, but given the low price of the stock, would have provided insufficient premium to achieve our goal. The first opportunity to sell calls would have been in mid-May as the stock rolled over from the $17.50 level. We would have sold 10 of the June $17.50 Calls for $0.75 each, taking in a total of $750. Those calls expired worthless in June, allowing us to keep our CSCO shares and then prepare to do it all over again.

Then we could have repeated that process both in July as CSCO rolled over from the $15 resistance level, using the August $15 Calls, which were then trading near $1.00. Net credit to the account for that transaction was $1000, and once again they expired worthless in the third week of August. Finally, in August, we got another opportunity as Stochastics rolled over from overbought, with CSCO once again unable to push through the $15 resistance level. Selling the September $15 calls at that time netted another $800 ($0.80 per contract) into the account, which we got to keep as expiration arrived with CSCO trading down in the $12 area. Adding up those credits gives us a total credit of $2550 into our account. In just 4 months, we would have reduced our cost basis for the long CSCO position from $20000 to $17450, and that would reduce our 40% paper loss to 31.2%.

Clearly we aren't going to get rich employing this strategy, but it is a solid and reliable method of repairing a stock position that is underwater, but appears to be consolidating prior to a resumption (hopefully) of an uptrend.

Of course, not every expiration cycle will be as kind to the covered call trader as those we highlighted here. Sometimes the stock will trade sideways or even move upwards. Initiating the trade as the stock rolls over from overbought helps to skew the odds in our favor, but as they say, "Stuff Happens!" We need to monitor the trade throughout the month, and if the price of the option moves above the credit taken in, then prudent risk control instructs us to buy back the calls and then look for another entry at a higher price. Recall that our objective here is to improve our cost basis in a stock position that is underwater. Key to achieving that goal is to not generate further losses by holding onto a related option position that is moving against us. Sounds like a perfect endorsement for using stop loss orders, doesn't it?

I realize this is a pretty short summary of how the Covered Call strategy can be utilized to repair a losing stock position, but hopefully it gets you thinking about what is possible. If you held the stock through the most recent decline, then you obviously have a long-term focus. Apply this strategy over a year or more and you may find that you can turn a losing stock position into a winner.

Questions are always welcome.


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