Options

Covered Calls – Part 2 – The Final Frontier

The second part of the article on Covered Call Writing looks at more detail and gives some examples.

Everybody screws up. It’s human nature. I spent the last article explaining what TO do ? and what NOT to do ? when using the covered call strategy. Did it sink in? I hope so.

Studies have shown that you have to be exposed to something a minimum of seven times before you comprehend it. So, read on. You may think you already understand what I’m about to explain, however, it’s more likely (if you’re relatively new to options) that you may be a little fuzzy on the subject.

Due to the seeming simplicity of trading covered calls, dozens of books have covered the topic. They devote chapters upon chapters painting blue sky with potential profits. It titillates that greedy part of the brain and sends inexperienced traders racing to the phone to put on covered calls. Unfortunately, these "would-be" traders rush in where angels fear to tread.

However, in these publications, only a few paragraphs explain what to do if the trade turns to mierde. But, it’s a rare occasion when someone will tell you "like it is." Well, as you know, that’s my mission in life. If your options therapist won’t tell you, who will?

I don’t enjoy the role as the prophet of doom, but someone has to do it. Don’t get me wrong. I don’t claim to have the cure for the disease. An ounce of prevention . . . and all that. If you’re going to trade strategies without all the information, eventually there will be financial pain, with fatalities not far behind. Your brokerage account will die a slow (sometimes not-so-slow) and painful death. It won’t do much for your ego, either.

What Went Wrong?
You had it all planned out. You bought 1,000 shares of JNPR stock at $21.30 and sold the next month’s $22.50 call option for $1.50. That $1500 looked so good in your brokerage account the next day, didn’t it? One week goes by, JNPR is at $21.75. So far, so good. You have dollar signs in your eyes. Another week passes. JNPR is at $20.45. Not bad.

Then, the Tuesday morning of expiration week, you turn on CNBC and hear that JNPR has announced an earnings warning, followed closely by a few analyst downgrades. JNPR is suddenly selling at $17.50. Wait! How can that be? You thought JNPR was going up. All your research said . . . yada, yada, yada . . . Well, Sherlock, you were wrong. The research was wrong. The market wasn’t wrong. It never is. YOU were wrong. Once you admit it, we can try to start salvaging what we can from this disaster. You’re staring at a $2,300 loss ($3,800 in stock less the $1,500 premium received).

A Possible Repair Strategy
First, you must have a legitimate belief (and not a result of puffing on that "hopium" pipe) that JNPR is capable of rebounding. If not, you should take your loss, lick your wounds, and find another vehicle (and perhaps another strategy) to use to make your money back. Setting a stop, buying back the short call and selling the shares is the prudent way to handle 75% of these situations. But, for the other 25% of the time, here’s an idea.

With JNPR now trading at $17.50, let’s check out some prices from an option chain for JNPR calls for the following month.

Stock Strike Bid Ask
JPNR $17.50 call 1.80 2.10
JPNR $20.00 call .90 1.10

 
You still own your 1,000 shares of JNPR stock. So, here’s what we can do.

  1. Sell 10 contracts of the $20 JNPR call for $.90
  2. Buy 10 contracts of the $17.50 JNPR call @ $1.80 
  3. Sell another 10 contracts of the $20.00 JNPR call @ $.90

The sale of the first 10 $20.00 calls (#1) is covered by your 1,000 shares of stock. In reality, it’s just another covered call. In #2 & #3, we’re buying 10 of the $17.50 calls and selling 10 of the $20.00 ? establishing what is known as a bull call spread.

Let’s take a closer look. Our total out-of-pocket expenditure is $1.80 for the $17.50 calls (#2). What are we bringing in? In steps #1 & #3 we brought in $.90 + $.90 — a total of $1.80. We spent $1.80 and we took in $1.80. So far, all this maneuvering has cost us nothing (except a few commissions) .

What have we accomplished? We have put ourselves into a position to double our participation in JNPR’s move back up. Therefore, in order for us to recoup our $2,300 in losses, JNPR does not have to go very far. We now have two assets working for us — the 1,000 shares of stock and 10 JNPR $17.50 calls.

Calculating Breakeven
Your JNPR shares were valued at $21.30 before you put on the original covered call position. When you put on the repair position, JNPR was trading at $17.50. You were facing a deficit of $3,800 in the shares less $1,500 premium received = $2,300. With the repair position, you would be participating in JNPR’s move TWICE as fast. If JNPR, at expiration, were to close at $18.70, your shares would have gained $1,200 (from $17.50) and your $17.50 call will be worth about $1,200. Together, the $1,200 and $1,200 will more than make up the $2,300 deficit.

Had you just held the stock, JNPR would have had to move all the way from $17.50 back to $19.90 ? a $2.40 move. Using the repair strategy enables you to recoup your losses when JNPR moves from $17.50 up to $18.70 ? only a $1.20 move.

What if . . . JNPR moves back up and closes over $20?

  1. Your 1,000 shares of JNPR stock will be called away at $20 (good riddance!) for a value of $20,000
  2. Your $17.50/$20 bull call spread will be worth the $2.50 maximum ($2,500) 
  3. That would give you a total value of $22.50. The value of JNPR when you first entered the position was $21.30. That means you will realize a profit of $1.20 ($1,200). This is the absolutely "best case" scenario. Don’t hold your breath waiting for this to happen. In general, when a covered call goes against you, the best strategy is to unwind your position and move on.

Reality
What you just read is possible in many covered call situations, but not all. The stock may not be at a good level or there isn’t sufficient premium to make this repair strategy work. In the above example, the repair strategy did not cost anything. It may actually cost a little to put on the additional bull call spread. Is it worth it? You’ll have to be the judge ? basing your decision on your realistic evaluation of the stock. Wishful thinking doesn’t enter into the equation. I know all about wishful thinking. Everyday, when I wake up and Carmen Electra isn’t making me breakfast, I suffer disappointment. The difference is that my wishful thinking doesn’t cost a thing.

 What do you think so far?
We’ve gone through the covered call strategy quite thoroughly. There is a lot to think about when (preferably before) using covered calls. It’s not a complicated strategy, but millions of people, who don’t know what they’re doing, are selling covered calls. Some may get lucky here and there, but, if they don’t know how to protect themselves and/or when to get out of a position, they can get hurt. They end up with a portfolio of loser stocks that went down ? and stayed there!

The Buy-Write
Many covered call traders are simply selling call options on stock they already own in an attempt to generate a better return on their investment. Others, however, will go out and buy stock specifically for the purpose of selling calls against it.

There are two ways of entering such a position.

  1. Place an order to buy the stock. Then, after the stock order is filled, place an order to sell the call option. This is a two-step process and is the one used by most traders ? because it’s all they know. However, it may not be the most efficient way. 
  2. Place an order to buy the stock and sell the option simultaneously for a net debit ? a one step process. This is called a "buy-write" ? "buying" the stock and "writing" (selling) the call at the same time.

How would we place a buy-write using our JNPR example? Let’s say . . .

JNPR is trading at $21.27 x $21.33 (bid x ask)

$22.50 option is $1.45 x $1.55 (bid x ask)

We learned in earlier sections that there is always a spread between the bid and ask prices. The bid/ask spread is where the market maker makes his living. If we want to buy JNPR (or option) immediately, we simply pay what the market maker is asking — $21.33. The order will be filled instantly. However, if we want to save a few bucks, we can try to negotiate with the market maker. Instead of paying the $21.33 for the JNPR, perhaps we would offer $21.30 or $21.31. Maybe he will compromise ? maybe not. If the negotiation attempt order is not filled right away, you take the risk of the JNPR moving up while you’re waiting. If it moves up, you may end up paying more than the $21.33, which defeats the purpose of trying to save a nickel or a dime.

If/when your stock order is filled, you may go through the same process trying to fill your order to sell the covered call. If you choose not to negotiate, you won’t have this problem. You won’t save any money, but you won’t have to spend the time and take the risks associated with working the orders.

The buy-write allows you to place the stock and option orders as a single order for a debit limit. More progressive brokers will have screens on their trading platforms that enable you to place these buy-write orders. Here are a few examples as to how you would prepare to place a "buy-write" order.

  1.  Buy 1,000 shares of JNPR and sell 10 contracts of JNPR $22.50 calls for a debit of $19.55. This is the debit limit we would use if we did not want to negotiate. It consists of buying at the $21.33 ask on the JNPR shares and accepting the $1.45 bid price on the $22.50 calls.
  2. Buy 1,000 shares of JNPR and sell 10 contracts of JNPR $22.50 calls for a debit of $19.80. What we’ve done here is take the amount we’d like to pay for the JNPR stock ($21.30/share) and subtract the premium we would like to receive for the $22.50 covered call ($1.50/share). This figure is our attempt to negotiate a little (about $.15) from the bid/ask spreads of the stock and the option. Now, $.15 may not sound like a lot. But, on 1,000 shares and 10 contracts, it amounts to $150. That’s meaningful ? at least to me. It’s 150 double cheeseburgers!

So, you can initiate a covered call either way. If you’re interested in the "buy-write" method, call your broker and see if they have the capability of entering the buy-write. If they don’t, you have the wrong broker.

If A "Covered Call Is Exercised" Alternative
Here’s something to consider for those of you who may be selling covered calls on stocks that you already own. Some folks are reluctant to sell covered calls on stocks because they are concerned about having the stock called away from them. Their stock may have been purchased a zillion years ago at significantly lower levels and, if called away, there would be substantial capital gain tax implications.

Now, as much as we all LOVE to pay taxes, we don’t want to give Uncle Sam any more than we absolutely have to. Agreed? With covered calls, there is some flexibility that is tax friendly. On Monday following expiration, when you are notified that your stock has been called away, there are three days before the transaction settles. All stock sales and purchases settle in three business days.

You have the time to go out onto the open market, purchase an equal amount of stock and designate the newly acquired shares to be the ones to be called away to satisfy the exercising of the covered call.

For instance, if JNPR closed at $24.10 at expiration, and you had sold the $22.50 call, your call would be exercised and your 1,000 shares of JNPR would be called away. However, if you buy another 1,000 shares at $24.10, you can designate the new 1,000 shares to be the ones called away. That way, you can avoid having to pay a capital gains tax. The new cost basis of $24.10 would apply to the shares called away ? not the cost basis from the original 1,000 shares at $21.33.

You would have paid $24.10 for the new 1,000 shares and you would only receive the $22.50 from the covered call you sold. But, you are not out the $1.60. Remember, you still own the original 1,000 JNPR shares ? that have now appreciated by that same $1.60-ish. So, it’s a wash ? and you still own the 1,000 JNPR shares.

Mike Parnos has "been there and done that" – plenty! Known as "OTA's Options Therapist," Mike has been trading, consulting and teaching option strategies for over 12 years. Both individually, and through his writings, Mike specializes in teaching conservative and non-directional option strategies while providing therapeutic guidance to thousands of individuals, brokers and institutional traders. Over the years, he has learned from his mistakes, and the mistakes of others, and he's here to share his wisdom with you. "Trading is as much psychological as it is skill," says Mike. "Keep an open mind. You never know what might find its way in there."

Mike Parnos has "been there and done that" – plenty! Known as "OTA's Options Therapist," Mike has been trading, consulting and te...