What to Do When a Covered Call Trade Moves Against You
Using a covered call strategy in your traditional investment account or IRA can be a tremendous way to generate income and grow your capital. The two major advantages of this strategy are that it can help you generate reliable returns on a periodic basis and that it has significantly less risk than a typical buy-and-hold strategy.
The one primary drawback is that you’re not going to shoot the lights out with this approach (although a reliable 25% to 35% return per year is pretty attractive). For a quick overview on how this strategy works, take a look at our covered call primer.
For the majority of our covered call trades, we buy stocks in 100-share lots and then sell call options to generate income. The calls typically expire in a four-to-eight-week window, and we usually hold the position until the calls are either exercised or they expire.
While most of the time it is best to hold covered call positions until maturity, there are times when it actually makes sense to close out the position early or make adjustments before the expiration date.
For a number of years, I was a trader at a hedge fund that managed a large book of covered call trades. Each month, we would buy tens of thousands of shares of individual equities for our clients. And then we would sell dozens of call contracts against those positions to reduce our risk and create additional income.
The only time that we adjusted our covered call positions midway through the contract life was when the stock moved dramatically in our favor or dramatically against us.
You see, when the stock remains close to the strike price of the call option contract, the overall position continues to generate income as the price of the option contract decays.
But when the stock price moves significantly away from the strike price of the option, the price of the option either moves very close to zero or very close to its “intrinsic value” (the amount that the option is in the money). In either case, there is virtually no more income to be made from the option contract, and we as traders need to figure out the best way to manage the position.
Let’s take a look at our options (no pun intended) in each case. We’ll start with risk management when the stock moves lower, and I’ll discuss adjustments we can make to positive trades in another article.
Adjusting Covered Calls When a Position Moves Against Us
One of the benefits of selling calls against a stock position is that we get to keep the money we received when selling that contract. When a stock declines or remains below the strike price, the contract expires worthless and our profit from selling the option can help offset any loss in the stock.
But sometimes the stock can drop far enough to where the option is trading very near zero, and we still hold the stock. In this case, sometimes it makes sense to adjust in one of three ways:
1. Transition out of the current contract into a lower strike price call option.
2. Close the position entirely.
3. Sell an additional call contract against the position (more risky).
For our example, let’s assume we bought a stock at $46 and sold the $45 calls against the position. If the stock dropped all the way down to $39, we may want to adjust our position in one of these three ways for the purpose of adding more income, or for the purpose of minimizing our risk.
Transitioning to a Lower Strike Price
When a covered call position moves against me, one of my first instincts is to close the call contract that I originally sold, and sell a lower strike price call option, which gives me additional income.
For this example, let’s assume that we want to transition out of the $45 calls and into the $40 calls. Obviously, the exact prices would depend on a number of factors, but let’s assume that we can buy back the $45 calls at $0.25 and sell the $40 calls at $1.75.
In this instance, the $45 calls are priced very low because the stock has pulled back significantly. The $40 calls have a higher price because the calls are much closer to the actual stock price. Our net credit for transitioning to the lower strike price is $1.50 per share, helping to offset some of the loss from the stock dropping.
This approach makes sense if we believe that the stock is still a solid investment and that it will not continue to drop. Keep in mind that if the stock trades back above $40 before the calls expire, we will be forced to sell our stock at the new strike price (and we still get to keep the premium for selling these calls).
Many online brokers will allow you to execute both trades simultaneously using their “spread” functionality. This way you can know ahead of time exactly what your credit — the difference between your buy price and your sell price — will be.
Selling the Position Outright
If we assume that there is risk of the stock continuing to fall or if the pricing of a lower strike call option is not particularly attractive, the best approach may be to cut our losses and sell the position outright.
With covered call positions, we actually need to make two transactions to close out the position. The first transaction will be to close the option portion by “buying to close.” This means we are buying back the option contract that we originally sold, and we typically have to pay a small premium to execute this trade.
Once you have bought your option contract, you are then free to sell the stock portion of the trade, which is a simple stock sell transaction. Most brokers require you to execute the trades in this order (option first, then the stock portion) to minimize your risk.
Selling an Additional Contract
If your brokerage account is set up with margin capabilities, you may have the option of selling an additional call contract against the position.
I want to be very clear here: This is an aggressive strategy with significantly more risk. You need to be very certain you understand the risks of this strategy before implementing it in your account.
For this approach, we may decide to continue to hold our short position in the $45 call contracts, and sell the $40 call contracts as well.
The benefit of this approach is that we don’t have to pay to buy our original contract back, and we still have the additional income from selling a new set of contracts. This strategy makes the most sense when the option contract we own becomes illiquid or our transaction costs are too high. (We’ll talk more about these situations in a future article.)
If the stock remains below $45, all is good. The $45 contract will expire and our $40 contracts may require us to sell the stock at $40, closing out the position when the calls are exercised. This would be the most profitable outcome.
But the additional risk in this situation is if the stock begins to rally and crosses over the $45 level. At this point, you would begin losing money for every point that the stock moved higher, because the additional call contract obligates you to sell 100 shares at $45, and you don’t have the stock to sell unless you buy it at a higher price.
An extreme example of this would be if the stock rallied to $65. In this case, you would have the obligation of selling 100 shares of stock per contract at $45. But you would not actually own the stock. So you would have to buy shares in the open market at $65 in order to fulfill your obligation, realizing a loss of $20 per share.
So you can see why this approach adds more risk and why you need to monitor your position carefully if you have sold additional contracts against your stock position.
Adjusting for Positive Outcomes
On the bright side, there are times when a covered call position moves so quickly in our favor that it makes sense to adjust our positioning to capture even more profits. We’ll cover this scenario in a future article as there are a number of different strategies for us to consider.
Do you have specific questions about how the covered call strategy works? I’d love to answer them in a future post. Please send your comments and questions to Editors@ProfitableTrading.com.