Covered Call, maintainance

Discussion in 'Options' started by cqm, Feb 25, 2012.

  1. cqm

    cqm

    I have some questions about covered calls. I've never done such a conservative strategy so I am seeking guidance on one scenario:


    On your very first position (stock + short ATM/OTM calls), what do you do if the stock goes down past the breakeven?

    Do you stop-out or hold it?


    The disadvantage to holding is that - although your call will expire worthless and you keep the premium - your stock position will contain shares bought at higher than the current ATM option, messing up your risk profile. So writing the next call would be a problem

    Example:
    Buy 100 XYZ at $50, Sell -1 March XYZ 55 Call @ 2

    Scenario 1: stock stays at $50 till expiration. collect $2 premium, sell April XYZ 55 Call @ 2

    Scenario 2: stock goes to $55 or higher at or before expiration. collect $2 premium, roll up, roll out, roll up and out whatever

    Scenario 3: stock goes to $45 at or before expiration.
    collect $2 premium. Rolling down (selling option at 45 strike) will have different margin requirements and risk profile because your stock position is at $50, and the stock could go back up.


    I always see covered calls advertised as a way to generate income AFTER you've been holding a stock investment for a long time and suddenly realized "oh hey, I can write calls"

    But on your first position how do you manage this on a stock decline, lets say even a gap down past your breakeven.
     
  2. I use the premium to buy additional shares at a lower price to increase my position.

    If you want to initiate a position you are better off selling the put at the strike price you feel would be a good entry point.

    And if you are put stock, sell the CC at a strike price you are willing to initiate an exit point on your long stock position.

    Save the premiums for times when you see a nice buying dip, you can use it to grab additional shares.

    I only do this on IWM and SPY on my long term portfolio.

    Don't over complicate things. And you will be fine.
     
  3. With CC's, breakeven is higher before expiration. As premium decays, BE drops. So if XYZ dropps immediately, you may never see BE.

    If XYZ drops, you have to decide if you're a buy & holder or a trader. If the former, you ride the bronco, possibly DCA-ing with more shares. You can roll your CC down but that only softens the damage. It's a losing proposition. If XYZ keeps dropping, in order to generate premium, you'll have to write at lower strike(s) possibly locking in a loss.

    I'm not a fan of rolling CC's up (your over $55 scenario). Here, you realize losses and carry paper gains and that's a recipe for disaster. Given the choice, I'd book gains and carry paper losses. In this case, I'd take the 7 pts, and move on.

    Despite the hype, AFAIK, a CC is one of the riskier strategies (think naked puts). You have limited return yet you bear all the risk. They have a miserable risk profile and you'll succeed only if you have good timing and selection.

    In most cases, I'd sooner go with a vertical or a diagonal than a NP.