Option Investor
Educational Article

Covered Calls III - The Fix Is In

HAVING TROUBLE PRINTING?
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Everybody screws up. Its human nature. I spent two entire columns explaining what TO do and what NOT to do when using the covered call strategy. Did it sink in? I hope so.

Studies have shown that you have to be exposed to something a minimum of seven times before you comprehend it. So, read on. You may think you already understand what Im about to explain, however, its more likely (if youre relatively new to options) that you may be a little fuzzy on the subject.

Due to the seeming simplicity of trading covered calls, dozens of books have covered the topic. They devote chapters upon chapters painting blue sky with potential profits. It titillates that greedy part of the brain and sends unexperienced traders racing to the phone to put on covered calls. Unfortunately, these would-be traders rush in where angels fear to tread.

However, in these publications, only a few paragraphs explain what to do if the trade turns to mierde. But, its a rare occasion when someone will tell you like it is. Well, as you know, thats my mission in life. If your options therapist wont tell you, who will?

I dont enjoy the role as the prophet of doom, but someone has to do it. Dont get me wrong. I dont claim to have the cure for the disease. An ounce of prevention . . . and all that. If youre going to trade strategies without all the information, eventually there will be financial pain, with fatalities not far behind. Your brokerage account will die a slow (sometimes not-so-slow) and painful death. It wont do much for your ego, either.

What Went Wrong?

You had it all planned out. You bought 1,000 shares of JNPR stock at $21.30 and sold the next months $22.50 call option for $1.50. That $1500 looked so good in your brokerage account the next day, didnt it? One week goes by, JNPR is at $21.75. So far, so good. You have dollar signs in your eyes. Another week passes. JNPR is at $20.45. Not bad.

Then, the Tuesday morning of expiration week, you turn on CNBC and hear that JNPR has announced an earnings warning, followed closely by a few analyst downgrades. JNPR is suddenly selling at $17.50. Wait! How can that be? You thought JNPR was going up. All your research said . . . yada, yada, yada . . . Well, Sherlock, you were wrong. The research was wrong. The market wasnt wrong. It never is. YOU were wrong. Once you admit it, we can try to start salvaging what we can from this disaster. Youre staring at a $2,300 loss ($3,800 in stock less the $1,500 premium received)

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A Possible Repair Strategy

First, you must have a legitimate belief (and not a result of puffing on that hopium pipe) that JNPR is capable of rebounding. If not, you should take your loss, lick your wounds, and find another vehicle (and perhaps another strategy) to use to make your money back. Setting a stop, buying back the short call and selling the shares is the prudent way to handle 75% of these situations. But, for the other 25% of the time, heres an idea.

With JNPR now trading at $17.50, lets check out some prices from an option chain for JNPR calls for the following month.
Stock Strike Bid Ask
JNPR $17.50 call 1.80 2.10
JNPR $20.00 call .90 1.10

You still own your 1,000 shares of JNPR stock. So, heres what we can do.
1. Sell 10 contracts of the $20 JNPR call for $.90
2. Buy 10 contracts of the $17.50 JNPR call @ $1.80
3. Sell another 10 contracts of the $20.00 JNPR call @ $.90

The sale of the first 10 $20.00 calls (#1) is covered by your 1,000 shares of stock. In reality, its just another covered call. In #2 & #3, were buying 10 of the $17.50 calls and selling 10 of the $20.00 establishing what is known as a bull call spread.

Lets take a closer look. Our total out-of-pocket expenditure is $1.80 for the $17.50 calls (#2). What are we bringing in? In steps #1 & #3 we brought in $.90 + $.90 -- a total of $1.80. We spent $1.80 and we took in $1.80. So far, all this maneuvering has cost us nothing (except a few commissions)

What have we accomplished? We have put ourselves into a position to double our participation in JNPRs move back up. Therefore, in order for us to recoup our $2,300 in losses, JNPR does not have to go very far. We now have two assets working for us -- the 1,000 shares of stock and 10 JNPR $17.50 calls.

Calculating Breakeven

Your JNPR shares were valued at $21.30 before you put on the original covered call position. When you put on the repair position, JNPR was trading at $17.50. You were facing a deficit of $3,800 in the shares less $1,500 premium received = $2,300. With the repair position, you would be participating in JNPRs move TWICE as fast. If JNPR, at expiration, were to close at $18.70, your shares would have gained $1,200 (from $17.50) and your $17.50 call will be worth about $1,200. Together, the $1,200 and $1,200 will more than make up the $2,300 deficit.

Had you just held the stock, JNPR would have had to move all the way from $17.50 back to $19.90 a $2.40 move. Using the repair strategy enables you to recoup your losses when JNPR moves from $17.50 up to $18.70 only a $1.20 move.

What if . . . JNPR moves back up and closes over $20?

a) Your 1,000 shares of JNPR stock will be called away at $20 (good riddance!) for a value of $20,000
b) Your $17.50/$20 bull call spread will be worth the $2.50 maximum ($2,500)
c) That would give you a total value of $22.50. The value of JNPR when you first entered the position was $21.30. That means you will realize a profit of $1.20 ($1,200). This is the absolutely best case scenario. Dont hold your breath waiting for this to happen. In general, when a covered call goes against you, the best strategy is to unwind your position and move on.

Reality

What you just read is possible in many covered call situations, but not all. The stock may not be at a good level or there isnt sufficient premium to make this repair strategy work. In the above example, the repair strategy did not cost anything. It may actually cost a little to put on the additional bull call spread. Is it worth it? Youll have to be the judge basing your decision on your realistic evaluation of the stock. Wishful thinking doesnt enter into the equation. I know all about wishful thinking. Everyday, when I wake up and Carmen Electra isnt making me breakfast, I suffer disappointment. The difference is that my wishful thinking doesnt cost a thing.

Who Is This Guy? --

Mike Parnos has "been there and done that" - plenty! Known as the MasterTater and "Options Therapist," Mike has been writing the profitable and popular Couch Potato Trader column (for optioninvestor.com) for almost five years. Hes been trading, consulting and teaching option strategies for over 12 years. Both individually, and through his writings, Mike specializes in teaching conservative and non-directional option strategies while providing therapeutic guidance to thousands of individuals, brokers and institutional traders.

For serious traders, Mike offers a comprehensive two-day seminar covering many fascinating and profitable non-directional strategies. Feel free to send questions and/or comments to Contact Support.

Over the years, he has learned from his mistakes, and the mistakes of others, and he's here to share his wisdom with you. "Trading is as much psychological as it is skill," says Mike. "Keep an open mind. You never know what might find its way in there."
 

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