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Four Steps to Solving Covered Call Risk


Market risk does not go away. Here's how to reduce it.

To many traders, it seems the covered call is the perfect strategy. Too perfect, perhaps?

Its fans point to the great "win no matter what" features:

1. If you pick a strike above your original cost, exercise produces a capital gain.

2. You receive a premium for selling and it's yours to keep.

3. To avoid exercise, you can roll forward, producing even more income.

4. The short call falls in value due to time decay, and you can sell it any time you want before expiration.

5. If the call expires, you keep all of the premium and can write another, and another without limit.

6. You earn dividends as long as you own the stock.

7. The call premium discounts your basis, providing protection against price decline.

That is a lot of benefit to a single strategy. In fact, covered call writing is considered one of the safest strategies around.

What could possibly go wrong?

The stock price may easily fall below your net basis. For example, on April 2, 2012, Research in Motion (RIMM) reached a high of $14.99 per share. If you had bought 100 shares at that moment and sold an April 21 call with a 15 strike, you would have earned 2.30 ($230). However, by April 4 two days later, the stock's price had fallen to $12.82 and the option was worth 0.12. Closing at this point would produce an option profit of $234; however, the stock had declined by $217. When you count the transaction costs, you would be at or below zero on the overall trade. So if RIM continued to fall, your net breakeven would turn into a net loss.

In this situation you can take several steps to avoid a loss:

1. Sell the stock. Avoid losses and accept outcome.

2. Close the short call and sell another, maximizing income with strike or expiration selection. You can still produce extra option profits and, hopefully, avoid a net loss on the stock.

3. Convert the position to a collar by buying a put. Any further price decline in the stock will be offset by growth in intrinsic value of the put.

4. Cover the position with a long call and dispose of the stock, converting the covered call to a spread.

Risk does not go away, it is only reduced. The downside market risk of a covered call is less than the market risk of owning stock, due to the premium income of that call. The upside risk (that stock will be called away and you will miss out of larger profits) is a different kind of risk that you have to accept in order to write covered calls.

The strategy is not a "sure thing" given that you still have to live with market risk. Even so, would you rather hold stock or maximize it with added income? That is the big question for covered call writers. For many options traders, the key to timing of trades is as important as picking the right stock and strike. To make this simple and easy, check Volatility edge for ideas on how to find great covered call positions. But remember, you also need to develop in advance both an adjustment and an exit strategy.

About the author: Michael C. Thomsett is an author with six options books published, including the best-selling Getting Started in Options (Wiley, over 250,000 copies sold in eight editions), and Options Trading for the Conservative Investor (FT Press, now in its second edition). The author is also the Chief Education Officer of -- a website devoted to helping traders pick high-probability options trades in a conservative trading program. Thomsett's website is
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No positions in stocks mentioned.

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