When Covered Calls Attack

03/28/2011 9:37 am EST

Focus: OPTIONS

A trader recently asked us for help regarding a covered call position he was holding. It’s an interesting situation that any option trader may find themselves in, so I wanted to answer his question here on MoneyShow.com.

“I have a question and wonder if you will help. I would appreciate very much any advice that you can offer. I have 100 shares of Green Mountain Coffee (GMCR) stock and I have written a covered call—June ‘11/ strike 43—against it. The stock gapped up from $41 to $57 recently. How can I repair my situation in that I am losing $1100 on the covered call yet I can’t sell my GMCR stock because of the covered call against it?” - Lee

One of the most popular directional options strategies is the “covered call,” which is also known as the “covered write.” The covered call strategy is basically a “campaign” that is predicated on a trader’s bullish opinion on a stock, ETF, or index. The strategy is often employed by holders of long-term equities who are looking to milk some extra income out of certain stocks in their portfolio. Other times, traders will simply select a single equity on which they have formed a bullish bias and undertake a covered call campaign around that stock.

Like every trade, there is an upside and a downside to the covered call. If the trader is “too” wrong and the stock sells off substantially, the trade will be a loser—at least in the short term—because the loss on the shares will outstrip the gain on the short call. If the trader is “too” right, the covered call will limit the trader’s upside to the appreciation that the stock will enjoy up to the strike price of the short call.

The trade will be a winner, but not as big a winner as it would have been to have simply been long the stock or long a deep-in-the-money call (a “synthetic” long stock position). However, if the trader is a little wrong or a little right, the covered call strategy will easily outperform a simple long position in the stock and can turn losing-share holdings into winning trades or flat, boring equity positions into outstanding winning trades.

In this case, Lee actually commenced his campaign cleverly by selling a naked October ‘10 $30 put on GMCR, picking up $138 in option premium, which he pocketed when GMCR was trading at $34 last September. GMCR then fell below $30 and he was assigned 100 shares of GMCR upon the expiration of his put. So Lee was off to a good start, picking up $138 in income on a stock that he was willing to own at $30 anyway.

Over the next three months, Lee cleverly milked his $3000 investment in GMCR stock by selling slightly out-of-the money calls and puts around his core GMCR long stock position then buying them back as the stock fluctuated in price, buying back  the calls and puts when they shrunk in value to a fraction of their original sale price.

The day before GMCR’s monster, one-day, $18 point rally a couple weeks ago, here was Lee’s position: In addition to holding the GMCR shares as they appreciated 45% above his original purchase price (the $30 per share that he shelled out when he was assigned the shares last October), Lee milked another 10% from his shares by skillfully selling calls and puts around his core long position.

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The day after the monster up move, Lee’s “campaign” was up 58% in six months—a very successful covered call campaign.

It is true that if Lee had simply purchased the GMCR shares at $30, his appreciation at the end of last week would have been closer to 100%. However, had the GMCR shares appreciated more gradually, the covered call approach would have almost certainly continued to handily outperform a buy-and-hold strategy. Again, if the trader is “too” right, the covered call strategy will be successful, but may or may not be as successful as buying and holding the shares.

So first off, I’d argue that there is nothing to ”repair.” This trade is a tremendous success. Lee just has to make a decision as to where he wants to go from here with this campaign. If Lee has achieved his planned objective on the trade or believes the stock is due for a correction, he can simply cover the call and sell the shares simultaneously, locking in his excellent gain.

On the other hand, Lee may think that the stock has further upside. If so, he can buy back the call, take the loss on the call (while still holding shares that are up almost 100%), and sell an out-of-the money call such as the April 65 or the June 65 or even 70. In this case, even if the stock sells off a bit, Lee could be in a better position than he is today because of his receipt of the new call premium he collected. It would all depend upon how steep the selloff is, and its timing. On the other hand, if Lee stays in the trade and his further bullish bias is correct, the profit and loss for his “campaign” will continue to improve.

Lee, great job on your covered call campaign! You don’t need a “repair” at all; you just need to decide whether your capital is better employed in a different trade with more potential upside and less potential downside, or whether you think your best risk/reward tradeoff remains in the GMCR campaign.

By Seth Freudberg director, SMB Capital Options Training Program

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