Follow-Up a Covered Call Position...

Many of our customers have asked for help in how to manage their Covered Call (CC) portfolios. Since PowerOptions is primarily a tool to find option investments, they are looking for tools or rules of thumb on how to exit the CC investment once it is established. The following suggestions are based on the philosophy of being hedged at all times. In the "General Tactics" below we assume you want to hold the stock for the long-term. Portfolio fluctuation should be more independent of the movement of the market because one would always have a covered call position. Being hedged at all times should minimize the volatility of the portfolio, and therefore limit both upward and downward movements in the value of the portfolio.

The management principals suggested should allow one to participate in 70% of the rise in stock price and limit losses to only 30% of the decline. These percentages work as long as the trading is orderly. If the company rises quickly because of a take-over or falls because of an accounting irregularity, the stock move could gap up or down. This would make it more difficult to follow the plan. In the management tactics discussed below the assumption is that a covered call was initially written at the money (ATM). Some investors specialize in an in the money (ITM) or out of the money (OTM) strategy. These strategies are discussed at the end of the tactics article.

Following your writes and knowing when to exit can be a difficult and exhausting game. The trick is to know when you should take action on your positions. It is possible to go out too early if you get nervous right away after a slight drop or rise in the stock price. Of course, you can also be too patient and wait too long to take any action.

When dealing with covered calls there are three main scenarios a writer must be attentive to as expiration approaches: What can be done if the underlying stock suddenly rises? What can be done if the underlying stock suddenly falls? What can be done if the stock price stayed the same? In each situation there are tips and guidelines that can be followed in order to exit the covered call position. Of course, each possibility mentioned above can also be affected by your covered call investing strategies. Do you write In the Money (ITM), At the Money (ATM) or Out of the Money (OTM)? Each strategy has different guidelines for swings in the market. The first strategy covered is the ATM case for a long-term holding.

General Tactics/Rules of Thumb:
Let's first discuss the general rules of thumb for exiting a covered call position. Exiting action should generally be taken at any time when the stock price moves to the next strike price from the original strike price that was written. If a stock is purchased at $20 and the next months $20 strike (This is the example we will use for this tip sheet) call is written, action would be taken when the stock moves to $17.5 (down) or to $22.5 (up). There is generally no rush to move immediately. In fact, if you give it a few days it will help the option prices stabilize and allow you to wring a little more time premium out of the position.

First we will examine the case of the stock falling:
(Stock is purchased at $20 and a 20 strike is written)

If the stock falls to $17.5, we would consider buying back the call written at the 20 CC. The option should have fallen in price to a considerably lower value than when originally written. Our objective would be to purchase it back at the lower price and write it again at a lower strike price so we remain ATM. We would consider writing the lower strike price out one month further in time, not necessarily in the same month as the original write. This would be especially so if the time remaining to expiration is only 1 or 2 weeks out. Therefore, we would track the stock down in price to maintain the hedge and get more option time premium for the falling stock. It should be noted that tracking the stock down like this assumes you want to maintain your position in the stock and that you have not changed your mind about holding on to it for the long-term. Each time that the stock drops to the next lower strike price you buy back the old option and write a new position at (ATM) or slightly in the money (ITM). It is important not to let the dropping stock price get away from you. If it falls too far without taking action you will loose the safety of the hedge because there will be very little premium to cushion any fall in the stock price. Remember, although you can continue to hedge your portfolio by following the stock down using this method, if the stock keeps falling you might want to reevaluate your position and decide if you even want to keep the stock.

Let's take a look at the case of the stock rising:
(Again, Stock is purchased at $20 with a 20 CC)

If the stock instead rises to $22.5, again we should consider buying the option back and writing the call at the $22.5 strike price. Buying back the short call may cost more than the original value of the write since the option is now ITM. How much the option will cost depends on how soon after the write the upward move takes place. The closer the option is to expiration when the upward movement of the stock takes place, the less the premium there will be since the time value has decreased. If the rise happens just after the stock purchase, the option premium will generally be higher. However, your holdings in the underlying stock will go up faster than the price of the option. Therefore there should always be a net gain. After the option is bought back, immediately write a new CC at the next higher strike price. You may also want to consider going further out in time to get more time premium and minimize the loss of the buy back. Generally the net cost of the buy back and new write should allow you to capture about 70% to 80% of the stocks rise in price. Again, it is important to track the stocks rise with timely buy backs if you want to participate in the rise of the stock. Since you are ahead when the stock rises, it may even be prudent to let the subsequent write be a little more in the money (ITM) as the stock rises. This will hedge the rise a little more, but also limit the complete participation in the rise of the stock price. Each time the stock rises to a new strike price, we should consider buying back the original CC and writing a new CC at the higher strike price and moving further out in time to retrieve most of our buy back costs.

The importance of Time Value:
Another consideration in timing the buy backs is to look at the time value remaining. On the PowerOptions site there is a column in the OptionChain tool called "% time value". This value is essentially the earnings for a covered call. When the time value gets too small there is little premium to be made from the covered call and it is time to take action. The purpose of taking action is to capture some more time premium. Time value is maximized when the stock price is equal to the strike price. As the stock rises or falls the time value will also fall. This creates the opportunity to buy back and roll up or down to collect a higher premium. Generally, when the time value falls to less than 2% you might want to start looking for buy back opportunities. When time value drops to 1% you should definitely consider taking action. The exception to this rule of thumb is when there is only about a week left to expiration. In this case we may just wait it out to avoid the buy back commission. Managing your portfolio in this way should reduce the volatility in the portfolio and stabilize your returns.

Deep In The Money (ITM):
Some investors use a deep ITM strategy to be more conservative and provide more down side protection. When a buy/write (buy the stock/write a covered call) is done ITM there is a smaller return, but the down side protection can often be 10% to 20%. These investors expect that their stock will be called and they will benefit from the return provided by the premium. If you are a conservative investor and do not want to tolerate the risk of a stock fall, the down side protection can be used as a stop point. Once the stock declines to the ITM strike price, the option price changes much more slowly with a stock price decline. Therefore, most of the protection comes from the ITM part of the premium. If the stock has declined the entire ITM amount of 10% to 20% it just may be time to liquidate and move on to another issue before the losses get too large. In this case you can hold the covered call position to expiration and let the option expire worthless or you could buy it back and write a new call at a lower strike price either one month or more out in time.

Rolling Out Your ITM Covered Calls:
Let's again take our example of XYZ at $20, and we are going to write a 17.5 strike. How can we roll these options out when the stock moves?

Scenario 1: The stock price drops from $20 to $17.5. Our covered call is now closer to ATM then ITM. If you wish to stay in the money and you think the stock price will not come back up, you can buy to close the 17.5 covered call and write out a 15 strike for the same month. In this case you might be able to collect more premium if you write the 15 strike one month out in time. The cost to buy back the original 17.5 may now be significantly lower than the premium you originally collected for it. The new write of the 15 strike will also give you a new ITM premium. Although this sounds good, keep in mind that you are still losing money on the underlying stock. If you are planning on getting assigned and you think the stock price will rebound from the initial drop, you can leave the 17.5 strike alone. In this case you want to watch the time value on the option carefully. Once the time value decreases to 2% or less, you might want to consider acting on the option.

Scenario 2: The stock price hovers around $20 a share. Your ITM option remains ITM. You will most likely get assigned at expiration. If you had planned on the stock dropping causing your 17.5 to be OTM at expiration, you can buy to close the 17.5 position and write a 20 or even a 22.5 strike for the next month out. The buy back cost of the 17.5 strike will cost you more then the premium you will collect from the new write. What you want to consider in this situation is did the premium you collect from the original 17.5 off set the $2.50 difference between the stock price and the strike price. If your collected premium was higher than the difference in stock price to strike price you may want to let yourself get assigned because you will have received more profit per share than if you sold the stock outright at $20.

Scenario 3: The stock price rises to the next strike price of 22.5. You are now deeper ITM. As with Scenario 2 you can buy back the 17.5 and write a 20 or a 22.5 strike price for the next month out. The buy back ask versus the new bid price will most likely be a negative value. Keep in mind that when you are rolling up with the market you may be losing money on the buy back costs of the option, but you are gaining money on the underlying stock. You can also simply close the position on the option and use the profit from the increasing stock to off set any losses you might have incurred.

Deep Out of the Money (OTM):
Some investors use a deep OTM strategy. These investors generally have held the stock for a long time and do not want it called away(assigned). It is anticipated that the vast majority of these trades will result in the option expiring worthless. Investors might also prefer not to heavily manage the covered call. Therefore, the strike price is generally chosen far enough out of the money (OTM) that it will not be called. The OTM strategy is also used by investors who think the stock may have a strong upward move. Writing more OTM will therefore allow you to participate in larger stock gains. If the stock price rises above this deep OTM strike price the option will generally be bought back to avoid being called. You can than write another call at a higher strike price to continue to participate in the upward movement of the stock.

If the stock declines the option premium will go down, but since it started OTM is will move down more slowly. Once the premium gets to a very low value i.e. $.05 or $.10 you may want to consider buying it back and rolling to a lower strike price and get some more premium. The exception to the buy back would be in the last week or two when it would pay to just wait it out to avoid the transaction commission.

Rolling Out Your OTM Covered Calls:
Let's again look at our example our XYZ stock selling at $20 but let's assume that we wrote a 22.5 Covered Call strike price. What can be done to roll with the market in this situation?

Scenario 1: The stock price drops from $20 to $17.5. Your covered call is now further OTM and will expire worthless. You will keep the premium that you have already collected for the position. To keep collecting premiums on the stock you can write the 22.5 out again for the next month out after expiration or you could also write the 20 strike if you felt the stock was going to remain down. If you notice that the stock continues to drop below $17.5 you might want to reevaluate your position on the underlying stock. If you continue to roll down with the market you will be able to hedge the loss on the stock but there will be a point when you lock in a loss and can not counter the loss in the stock price with the premiums form the options.

Scenario 2: Stock price hovers around $20. You are still OTM. The option will expire worthless and you will keep the premium. You keep the stock and can write another contract for the next month out at the 22.5 again or at the 20 strike if you want to try and collect a higher premium.

Scenario 3: The stock rises to $22.5. You are now ATM and could have to deliver the stock if the stock price rises slightly above $22.5. In this situation though you bought the shares at $20 and have gained $2.50 on the stock as well as the premium collected. If you want to hold on to the stock and not get assigned you can buy back the 22.5 strike price and write out another option at the 25 strike for the current month or the next month out. If you do this you will not get assigned at expiration but you will pay more to buy back the 22.5 than you will collect on the new 25 strike, but you still have the $2.50 profit on the stock. Play with the numbers and the calculations. It might be in your interest to let the option get assigned at the 22.5 strike price for more profit.