Managing Your Covered Calls

Many people like to write covered calls for monthly income. I also write covered calls as part of my investment portfolio. Unfortunately, I can usually find little information about how to manage them once they are written. This article will address that deficiency, and I will comment about how I like to handle certain situations given my almost 10 years of experience with options.

After writing a covered call, there are essentially 3 possibilities that can exist:

• The stock will have remained unchanged.
• The stock will have decreased.
• The stock will have increased.

Let’s discuss each situation and the approach that should be considered.

This is a very easy situation to handle.  Assuming that the strike price of the covered call option is greater than the current price of the stock, simply allow the call option to expire.  The next trading day, write another call option at the same strike price for the next month.  For example, you own 500 shares of AAPL and wrote a call option with a strike price of 165 when it was trading at 163.  On expiration day, the stock was again at 163 so the call expired.  The next trading day, you would write another call option with a strike of 165 and collect your income for the next month.

If you had written for the 160 strike on AAPL when it was trading at 163, then just before the expiration date, you would want to buy back that option which would probably cost about $3.10 and sell the 160 strike for the next month.  This is called rolling out because you are rolling out one month in time.  If you felt that the market was bullish and would be so for the next month, you could roll out and roll up to the 165 strike price all at the same time (I will discuss my thoughts below on this scenario below).  It is unlikely that a stock would remain perfectly unchanged, but if only different by a percent or two, then this is effectively the same idea.

If the stock is decreasing, then you are probably wishing you hadn’t purchased it to begin with since the object of investing is to make money and not lose it.  However, if you are managing a portfolio of covered calls, you will eventually run into this problem.  If you feel that the slump is temporary, you have a few choices.  You can let the call expire when it normally would.  Then you would have to decide whether or not you want to sell the same strike at the next month or move down a strike price.

If there still is a lot of time until expiration, you could consider buying back the call that you sold and selling a lower strike price.  This is called rolling down.  Alternatively, you could sell the lower strike and sell it for the next month, known as rolling down and rolling out.  I will tell a story about my experience with this in the personal comments section.

If the stock is increasing, you are probably second guessing your decision to sell calls in the first place since you are missing out on potential gains.  Your first option is to buy the calls that you sold back and ride the upward trend.  Alternatively, you could buy them back and roll up or roll up and out.  Finally, you could be content with the fact that you will make some profit from the sale of the calls and move on to the next stock.

First, let me share with you a story about a stock that I purchased and that ended up decreasing. The stock was PSINet (symbol PSIX). This was in late 1999 and early 2000 during the internet bubble. PSINet was an internet service provider that is long bankrupt. I purchased the stock in the 60’s and sold some calls. It turns out that the stock started declining. I purchased the calls back and was starting to get the feeling that this wasn’t going to turn out all that well. I could have sold but would have taken a loss, so instead I sold some calls that were in-the-money (ITM). That means the stock was trading at 55, but I sold the 50 calls. The stock kept declining, but I was managing to profit from the calls as the call premium evaporated. I kept buying back calls and selling ITM calls. I eventually got to the point where I had made enough profit on the time premium of the calls to buy back a set of calls and sell the stock at $20/share to break even. I was fortunate that the decline occurred over a few months and wasn’t suddenly overnight. I do a better job of protecting myself in this regard now but that is a subject for another day. The point is that it is possible to not lose money in a stock that has dropped 66%, but you must be vigilant and sell ITM calls on the way down.

Another example is that of a roll up and out. Just this year I was able to buy back EMC 13 calls while EMC was trading around 13.20. I then sold the EMC 14 calls for a few cents higher than my cost for the 13 calls. That gave me the potential for another dollar of profit on EMC, and I even got paid to do it! This past Friday EMC closed at 15.06, but my thinking on stocks that are increasing is to roll up and out but do so with ITM calls. EMC or any other stock is not going to go straight up. It will pause and consolidate which will give you time to catch up with your call strikes. You will not be giving up much profit unless there is a buyout of the company. If you are concerned that you might miss out on the big payday with a buyout, then you can sell calls on only a portion of your stock. I currently own ONXX which I think is a buyout candidate. For this reason, I only sell calls on half of the stock. I can make something while I wait for the buyout, but won’t miss it entirely. (I have been waiting almost a year). Anyway, there is a lot more that I would like to discuss. Maybe someday I will write a book on this. In the meantime, enjoy some of my other option hubs.