On 12/9/2022, Patrik sent me an email he titled “Covered Call Panic” He shared with me information on his trades and was distraught at the current outcome. This article will analyze whether Patrik actually needed Kleenex to cry over these trades or, perhaps, champagne to celebrate.
Patrik’s email to Alan
Hi Alan,
I read an in-depth article of yours about covered calls and as a newbie, I’m currently in quite a pickle that I’m trying to understand and potentially do something about!
I got 1000 shares of $Bili and placed covered call options on them with strike prices of $14 and $17 and unfortunately the stock flew up during these past two weeks to $24 where the little bit of premium received (~$2K) is nothing compared to the current gain of the underlying long stocks (~$10K). The covered calls are due mid-January. Is there any way I can reverse/sell/execute/assign them earlier for a profit here – or am I doomed to hold on until mid-January and will have to be satisfied with just the premium received upfront?
I’m a newbie to covered calls and can’t find an answer to this on Google! Any help/guidance from you would be super appreciated!
Best regards,
Patrik
BILI/ S&P 500 1-year comparison chart
BILI: Volatile Chart Pattern
The blue arrows show the volatility of BILI which is a reflection of the high risk and impressive option premiums inherent in these trades. Patrik did not share with me all the specifics of these trades, but certain conclusions can be made and a decision, at this point in time, if we are headed for the Kleenex or champagne.
Alan’s responses to Patrik
Hi Patrik,
No need to panic.
A few comments you should find useful:
- As long as the $14 and $17 calls are in place, the shares can be worth no more than those strikes
- As of now, you have an unrealized maximum gain on these trades as they were initially established (accepted the premium and agreed to sell your shares at the strike)
- You do not have to wait to close the trade, you can close at any time by buying back the calls and selling (or holding) the stock
- Buying back the call, will make the shares worth current market value, but the cost will be the difference between the strike and current market value + a time-value component
- As an example, if you sold the 1/6/2023 $17.00 call and shares are now worth $25.76, the posted cost-to-close the $17.00 call is $9.70 per-share. If that is done, shares are now worth $25.76 or an additional $8.76 above the previous strike. This means, you are paying $0.94 in time-value to close the $17.00 call. You can then sell a higher strike call if you feel that share price will continue to accelerate
- Bili is an extremely volatile security. It can go down as fast as it went up. Great premiums, but great risk with these type of underlying securities
- Bottom line: You haven’t lost $. You have maximized your profits (unrealized until the trade is concluded) as the trade was initially crafted. In other words, champagne rather than Kleenex in this case.
Best regards,
Alan
Discussion
Patrik accepted the premium return as the trades were initially established and, when share price accelerated, had significant downside protection of the maximum profit. If we have embraced a particular strategy and have maximized the returns on trades using this investment approach, which cabinet should we head for? It is an exercise in futility to say that if another strategy was used, a better outcome would be realized. Let’s enjoy our successful trades and head for the champagne.
One other thought
When share price accelerates well above our covered call strikes, we can consider the mid-contract unwind (MCU) exit strategy. This may create an opportunity to generate greater than a maximum return with the same cash investment. Click here for is a link to an article I published on this topic.
This, and all other exit strategies, are detailed in my 8th book, Exit Strategies for Covered Call Writing and Selling Cash-Secured Puts.
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Exit Strategy Choices After Exercise of Cash-Secured Puts
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A popular large-cap technology exchange-traded fund, Invesco QQQ Trust, will be used to establish rules and guidelines to benefit in these market circumstances.
July 10th -11th
Covered Call Writing: Multiple Applications Based on Current Market Conditions
Real-life examples with Invesco QQQ Trust (Nasdaq: QQQ)
Covered call writing is a low-risk option-selling strategy geared to generating cash flow with capital preservation a key requirement. This presentation will demonstrate how the strategy can be crafted to benefit in all market environments. Market situations highlighted are:
- Normal to bull markets
- Bear and volatile markets
- Low interest-rate environments
A popular large-cap technology exchange-traded fund, Invesco QQQ Trust, will be used to establish rules and guidelines to benefit in these market circumstances.
Date and time to follow.
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Alan,
I read several of your books on covered call writing and learned so much. I’m now reading cash secured puts. I know you use both itm and otm for calls but mostly otm puts. What is the best way to decide on which otm put strike to use?
Thanks a ,lot,
Marty
Marty,
Step 1: Identify your initial time-value return goal range for the trade setup. For example, I use 2% – 4% for my initial monthly positions, calls or puts. This is based on strategy goals and personal risk-tolerance.
Step 2: Make an overall market assessment (bullish, bearish, neutral etc.). Evaluate chart technicals for underlying securities.
Step 3: Based on Step 2, select strikes that generate closer to the 4% (or higher end of your personal range) for bullish markets and charts; closer to 2% (or the lower end of your range) for bearish and volatile markets and mixed chart technicals.
If overall market is not clearly defined, we can use a combination of bullish and bearish strike selections.
Alan
Hi Alan,
I’m working my way through your books.
Q about the 20%/10% rule.
I understand the exit strategy, just not sure where you are reinvesting.
Are you selling options that still expire within the same month, or are you then doing 5-6 weeks on the next cycle, with the redeployment of funds? And then would you be looking for a higher rate than the standard 4 week cycle?
Audrey
Audrey,
Technically we could use the current or a latter expiration. I almost always only use the current contract expiration, unless I am rolling-out or out-and-up as expiration approaches.
This simplifies management of my multiple option-selling portfolios … each portfolio has all positions with the same expiration date. If a particular portfolio is using monthly expirations, all expire on the 3rd Friday of the calendar month. Weeklys, on Friday of that week.
This approach has worked quite well for me for, now, 2+ decades of trading options.
Alan
Hi Alan,
Thank you for the explanation.
So, you keep multiple portfolios then? I was actually thinking of dividing my SEP IRA in half. ½ for options, ½ for growth stocks, without options.
Interesting though to have it divided to sections based on weeklies or monthlies.
Do you ever use LEAPS, or the longest is monthlies?
Audrey
Audrey,
I never use LEAPS as my short option positions.
Here are a few reasons:
1. Longer-term options yield lower annualized returns.
2. Give up opportunities to re-evaluate our bullish assumptions on the underlying securities.
3. Subject ourselves to the risk of multiple earnings reports.
I use mostly monthly expirations, some weekly expirations. Both work.
Alan
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Alan,
Just to share my pity story- had 500 shares of AVGO (Broadcom) . Had $700 calls 1/25 expiration after several roll-ups.; AVGO shot past to over $800. Sold 400 shares and bought back 4 options. Hanging on to 1 option and selling puts to try to regain some $.
My cost basis after dividends and options trades is $421 over 3+ years so I made a profit but left over $100,000 on table.
My mistake was to get too “cute” with a volatile stock, but could never have expected the unbelievable rise in so short a time period.
Had some success on SMCI but it too ran away; subsequently sold puts and made some $.
I continue to learn and refine my options strategy as time progresses. Getting more conservative as I gain experience.
For example, own 3700 shares of Apple (cost basis $25/ share)- do not sell options on this stock. By the way funded my daughter’s law school.
Anyway- just sharing.
Bob
Bob,
LEAPS offer impressive initial returns and can be quite tempting. We should also factor in that longer-term options yield lower annualized returns, eliminate the advantage of frequently re-assessing our bullish assumptions on the stock or ETF and force us to incur the risk of multiple earnings reports.
I, too, used options to assist in funding my sons’ college and professional school educations … nice going.
Finally, another way to view the current status of your trades with AVGO: you are in a great position to maximize your returns as the trade was initially established.
Bottom line: Re-evaluate the pros & cons of LEAPS in our covered call writing positions.
Alan
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Hi Alan,
I have a question for you suppose I buy a stock for $40 and sell the option for one dollar around what the stock price reduces to $36 now I have only got one dollar for the call that I sold and $40 I bought so I am three dollars in loss kind of so what should I do should I sell a call for to gain maximum profit which is around the strike price of 36 or 3738 or I should Scussel the next option on 39 which is kind of my breakeven or 41 or 42 whatever it is but the the premium on that is very low.
So in summary, what is the best strategy in case the stock loses a lot of money like 10% of the 10 or 15% and we have only like got to 3% from the call option.
Rgds,
Pankaj
Pankaj,
Your dilemma is an important one: how to manage trades where share value declines below the breakeven price point?
In my books and videos, here are some of the steps to mitigate these scenarios:
1. Always have the 20%/10% BTC limit orders in place to give us guidance as when to close our short calls.
2. Consider the possibility of rolling-down, looking to “hit a double” or selling the stock based on our 7% guideline after closing the short call.
3. All trades and trade adjustments (exit strategies) are based on our stated initial time-value return goal range, personal risk-tolerance and overall market assessment, NOT on previous trades. The price we paid for the stock in the past should not impact our best trade adjustments in the future.
4. Not all trades will be winning ones. Our mission is to mitigate losses, enhance gains and, in some cases, turn losses into gains.
Great question that I have addressed in all my material over the past 16 years.
Alan
Hi Alan
I was analyzing the percentage change in the stock with respect to the percentage change in the price of the covered call option.
Let me know if there’s a general correlation which we. Can use to determine if the call option drops to 20% of the original price. What is a percentage change in the price of the stock or underlying stock.
Thank you.
Pankaj
Pankaj,
The % change in an option value as it relates to the dollar change in the price of the underlying stock or RETF is known as its Delta. For example, if an option has a Delta of 35, it will move $0.35 up or down for every dollar change in share value. Delta stats can be viewed in most option chains.
For more information on delta:
https://www.thebluecollarinvestor.com/delta-defined-from-three-perspectives/
Alan
Hi Alan,
I know you recommend OTM calls and how much out of the money they should be before I sell a covered call?
Thanks,
Jolly
Jolly,
Although I do favor OTM calls in most market conditions, there are many times where ITM calls are preferred (bear & volatile market conditions, as examples).
To determine which strike to select, use one of the BCI spreadsheets to evaluate which strikes (ITM or OTM) meet the stated initial time-value return goal range.
Let’s say our goal is an initial time value return of 2% – 4% per-month. If we are choosing an OTM strike, check the option-chain for OTM strikes that generate that stated goal. We must know our goal before selecting a strike.
Alan
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Hi Alan
I’m a fan of yours, as you may know by now. I wondered if you could say whether it was more profitable to Call sell one of the 11 segments as the “covered” or use one of the firms inside that segment.
Your opinion would be appreciated.
Thank you.
Malcolm
Malcolm,
As it relates to the Select Sector SPDRs ETF, using 1 of the sector ETFs will provide much greater diversification than 1 individual stock. It will also allow for less time management and no earnings report concerns.
The advantage of using 1 stock, is the probability of greater premium returns as stocks generally (not always) have greater implied volatility than ETFs, and therefore higher premiums.
Both individual stocks and ETFs will work. The decision is based on strategy goals, personal risk-tolerance and time available. However, appropriate diversification is a must in all portfolios.
Alan