3 Ways To Adjust Your Covered Call Trades For Maximum Profits

One of the benefits of the covered call strategy is that it can be a “set and forget” type of approach. This means we simply set up our positions by buying a stock and selling call options. Then, we wait until the option contracts expire. It’s that simple.

Or is it? After all, sometimes we may need to make adjustments…

The majority of covered call positions are held until maturity. But there are certain times when it makes sense to adjust a position before the options expire. This can help reduce risk or capture an even bigger profit. Today, we want to primarily focus on how to adjust a position to maximize profit. (But as you’ll see in a moment, factoring in risk is always part of the calculus.)

Anatomy Of An Accelerated Covered Call Position

Let’s say we have a covered call position that moves sharply in our favor. It’s important to understand both why and how to take advantage. So let’s set up a hypothetical trade to see exactly how the different components of the trade work together.

Let’s assume we are buying theoretical ETF ABC, which is trading around $16.88. Then we sell call contracts against the position. (Remember, this is a hypothetical example, not a recommendation.)

  • Buy ABC in 100-share lots at $16.88
  • Sell calls contract that expire in one month with a $17.50 strike price at $0.20
  • Net cost: $16.68

With this trade, the best-case scenario for us is that ABC trades above $17.50. This means we must sell our stock at that price. In this case, we recognize a maximum profit of $0.62 per share. That’s a 3.6% return in a few weeks’ time.

Now let’s assume that ABC rallies sharply over the next few days. The ETF is now trading at $21.50.

In this situation, the $17.50 calls would immediately trade higher, likely to a price near $4.10. Why do we say $4.10? Because option buyers have the right to buy the stock at $17.50. They can then turn around and sell it in the open market for $21.50, recognizing a $4 profit. The extra $0.10 would be the remaining time value of the option.

The option contracts should not trade much higher than $4 because the calls are now deep in the money. (For statistical reasons, deep in-the-money calls wind up trading very close to their “intrinsic value.” This is the difference between the strike price and the actual stock price.)

From our perspective, we would now own stock that is worth $21.50 per share. We’d also be short calls that are trading at $4.10 per share. With these prices, we already have $0.52 of profit baked into the position. But we only have another $0.10 of potential profit to go.

More importantly, we have our capital tied up in this trade for another three to four weeks. And that’s with little or no new profit available to us. In our opinion, this is a waste of trading capital. We could be earning a return by entering a new position with more opportunity instead.

So let’s take a look at how we might adjust this position to continue profiting.

Three Adjustment Scenarios

Our decision of how to adjust the position depends on a few different factors. It is important to evaluate how ABC might trade from this point. We also want to evaluate what kind of opportunities are available in addition to ABC. And finally, we need to know just how much capital we have available in our account for adding new trades.

With this information, we’re going to make one of three possible adjustments:

1) Close the position outright

Let’s say we’re in a target-rich market environment. There are a number of attractive covered call opportunities to pursue. In this case, it may make sense to forego the last $0.10 of potential profit in this trade. Better off to just close out the position.

Keep in mind that if we close out the position, we will only book a profit of $0.52 for the trade. But at the same time, we will free up our capital. We can then trade a new position that could net us much more over the next few weeks.

This is a classic “opportunity cost” equation. We give up a small amount of potential profit ($0.10 in this example) for the opportunity of booking a much larger profit on a new trade.

2) Transition to a new strike price

Another option would be to buy back the calls with a $17.50 strike price. Then, we sell call contracts for a higher strike price. This gives us more potential gains without disturbing our stock position.

This approach would make sense if you were still bullish on ABC. You’d also want to have confidence there is a relatively low probability that ABC would back off.

One benefit of this approach is that we are not forced to sell our stock position. We can use our broker’s “spread trade” functionality to ensure we get a good execution for our trade. Most brokers will let you enter both sides of the trade as a single order with a limit price for the full transaction.

3) Add another layer to the position

One other option is to add another layer to the trade. To do this, we buy more shares of ABC and sell a new set of calls.

This approach would make sense if you have plenty of capital available for the trade. (Especially if you are trading with a margin account.) This also makes sense if you are worried about short-term tax ramifications.

But the bottom line is that you could buy more shares of ABC as well as a new set of calls. Then later on, you determine which lot of stock you want to exercise against the original calls.

This approach gives you more flexibility. And it still allows you to capture another block of profit if ABC continues higher.

Bringing It All Together

As with most profitable trading strategies, there is a level of simplicity that allows for healthy, predictable profits. And then there’s another level that allows for even stronger profit potential…

Ultimately, what you decide is up to you.

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