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Covered Call Going Against You? Here's Your Playbook

Wednesday, January 29, 2014 - 7:00am

The covered call strategy can be a very effective approach to boosting the amount of income you generate from your investment portfolio. In fact, when things are going well and the stocks that you use remain stable or increase in price, it is not unreasonable to target returns between 25% and 35% per year.

The approach takes a certain amount of maintenance, as we typically set up trades that expire over a four- to eight-week timeframe. But the time investment usually turns out to be worthwhile considering the reliable income stream that is available.

Although the covered call strategy is fairly easy to implement, the true key to long-term success is being able to manage risk when trades do not go as planned. Proper risk management will allow you to keep your capital base intact, which in turn allows you to make up any losses quickly and continue your process of generating investment income.

Before I explain how to manage risk when stocks decline, let's first take a quick look at how the covered call strategy works. To begin with, we purchase shares of a stock that we believe will be stable or move higher. We then sell call options against this position, generating income in our account.

By selling the call option, we are giving the buyer the right (but not the obligation) to purchase shares from us at the option's strike price. We therefore have an obligation to sell our shares at the agreed upon price, providing the stock is trading above this price when the calls expire. Keep in mind that each call option contract represents 100 shares. So we will want to buy 100 shares of stock for every call option we intend to sell.

As payment for taking on the obligation to sell our stock, we receive a payment called a premium when we sell the option contracts. Depending on the strike price, the date on which the contract expires, and the volatility of the underlying stock, that premium can often be very lucrative.

Using A Strike Price Near The Market Price
As a general rule, I like to sell call contracts with a strike price that is in the neighborhood of the current strike price. Depending on the market environment, the volatility of the underlying stock, and the fundamentals of the company, I may sell call options with a strike price slightly above or slightly below the current stock price.

One of the reasons that I like to sell call contracts with a strike price near the current market price is that these call options typically have the highest time value. This is the portion of the options value that is not "intrinsic," or already reflected by the current stock price.

As an example, take a stock that is currently trading at $51. A two-month call contract with a $50 strike price may have a premium of $4. This would represent $1 in intrinsic value (the value of the call simply from exercising the right to buy stock at $50 and sell it at $51), and $3 in time value. On the other hand, a $55 call option would likely trade close to $1, representing zero in intrinsic value (because there is no value in being able to buy stock at $55) and $1 in time premium.

In addition to the extra amount of income from selling a call option with a strike price near the current market price, call contracts with more premium actually give us more protection if the stock price falls. For instance, if the stock were to fall to $45, we would lose $6, but that would be offset by the premium we collected when selling the option. So if we sold an option for $4, we may only lose $2.

Adjusting A Covered Call Position For Lower Prices
Whenever I have a covered call trade that begins to move lower, the first thing I do is calculate how much protection I have with the current call option. The key is to make sure that the amount of money that I am gaining from selling the call option is material compared with the amount of money that could be lost as the stock price moves lower.

One of the best ways to mitigate losses when the stock is moving lower is to sell an additional call option at a lower strike price. This lower strike price will naturally have more premium because the buyer of this call option will have the right to buy stock at a lower (i.e., more attractive) price. For traders with a margin account, it is possible to sell the additional call option contract while still leaving the original call contract in play.

Of course, this introduces a new risk. If the stock remains below the strike price of the first option contract, then we won't be at risk. However, if we have two sets of call contracts sold, then we could lose additional money if the stock trades higher. Whenever you have two sets of call contracts sold, it is important to monitor the stock, and if it begins rebounding, it is usually best to either close out one of the call contracts or buy additional stock.

For this reason, most non-margin accounts (including IRAs and other qualified accounts) will not allow you to sell multiple call options against a stock position. In this case, the best way to protect yourself from a falling stock price may be to buy back the call option that you originally sold (at a lower price because the actual stock price is lower), and then sell a new call contract with a lower strike price.

Most online brokerage platforms have a function that allows you to execute these trades simultaneously. You can even set a limit order for the net price you would like to be paid for the entire transaction. I would recommend taking advantage of this feature to minimize the amount of slippage when exiting one contract and entering another.

Action to Take --> As with most investment strategies, the most important concept is not determining how to actually generate the profits. Instead, the most important skill to learn is how to protect your profits when things aren't going as planned.

This article originally appeared on ProfitableTrading.com:
How to Protect Yourself When a Covered Call Trade Is Losing Money

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Zachary Scheidt does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.