Covered call writing is used predominantly to generate cash flow in a low-risk manner. But it can also be used to exit stock positions while mitigating losses in those trades. As an example, I will use a series of trades shared with me by Ashvin on May 16th, 2019. The underlying security was iShares MSCI Brazil Capped ETF (NASDAQ: EWZ).

Ashvin’s trades

  • 1/17/2019: Buy EWZ at $43.09
  • 1/17/2019 – 4/22/2019: Write monthly out-of-the-money calls to generate cash flow
  • 5/16/2019: EWZ trading at $38.24 with the 5/17/2019 short call deep out-of-the-money
  • 5/16/2019: Looking for a plan to exit the under-performing EWZ and mitigate share loss

Ashvin’s proposed plan

Selling the 6/21/2019 deep in-the-money $22.50 strike would generate a bid premium of $19.60. Assuming the option is exercised at expiration, the loss per-share would shrink to $0.99 per-share. This would not even include the premiums generated to date. Here’s the math:

$43.09 (original purchase price) – [$19.60 (call premium) – $22.50 (shares sold at the strike)] = -$0.99

Breaking down the math with The Ellman Calculator

covered call writing calculations

EWZ Calculations with the Multiple Tab of The Ellman Calculator

The spreadsheet highlights some critical points we must be aware of when making our investment decisions:

  • There is a huge time-value return on our option of 17.2% which results in significant mitigation of share loss
  • There is also huge downside protection of 41.2% of that time-value profit

Digging deeper into these numbers

The option premium (time value + intrinsic value) tells us that the market is anticipating substantial volatility in EWZ and doesn’t specify direction. All the benefit and good news reflected in the spreadsheet must be tempered by the understanding of the risk to the downside for this high implied volatility security. If this trade is executed, it must be carefully monitored and perhaps closed should we see that downside protection eroding rapidly.

Discussion

Selling deep in-the-money call strikes is a viable way to close a long stock position and mitigate losses when there is a time-value component to the premium. Options that offer significant time value returns with substantial downside protection have high implied volatility and so we must be prepared with our exit strategy arsenal, if needed.

Your generous testimonials

Over the years, the BCI community has been incredibly gracious by sending our BCI team email testimonials sharing stories as to what our educational content has meant to their families. Moving forward, we have decided to share some of these testimonials in our blog articles. We will never use a last name unless given permission:

Alan, 

I calculated the past year’s paper-traded returns to an unbelievable 29.57%. These results could have been even higher because I didn’t play the B/A spread. I will definitely use this skill on real orders. So yeah with returns that high I actually can’t wait to start CC’s in real-time.

Adrian

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I have accepted an invitation to be interviewed on this program on Monday December 2nd at 3 PM ET – 4 PM ET. I’ll provide more information as I receive it.

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