Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

Four Steps to Solving Covered Call Risk

By

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

PrintPRINT
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 conservativetrade.com -- a website devoted to helping traders pick high-probability options trades in a conservative trading program. Thomsett's website is www.michaelthomsett.com.
< Previous
  • 1
Next >
No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.

PrintPRINT
 
Featured Videos

WHAT'S POPULAR IN THE VILLE