One of the benefits of the covered call strategy is that it is
usually a "set and forget" type of approach. By that, I mean that
we can set up our positions (buying stocks and selling call
options), and then wait until the option contracts expire to make
#-ad_banner-#While the majority of covered call positions are
held until maturity, there are certain times when it makes sense
to adjust a position before the options expire in order to reduce
risk or to capture an even bigger profit.
We've previously covered adjustments to covered call positions
for the purpose of risk management. Today, I want to focus on
adjustments to covered call positions that move dramatically in
our favor. In these situations, the objective is to maximize our
profit and make the most efficient use of our capital.
Anatomy Of An Accelerated Covered Call Position
To understand both why and how to take advantage of a covered
call position that moves sharply in our favor, let's set up a
hypothetical trade to see exactly how the different components of
the trade work together.
For our example, let's assume we are buying the
iShares Silver Trust (NYSE:
and selling call contracts against the position. (Remember, this
is an example, not a recommendation.)
-- Buy SLV in 100-share lots at $21.85
-- Sell calls contract that expire in one month with a $22 strike
price at $0.70
-- Net cost: $21.15
With this trade, the best-case scenario for us is that SLV
trades above $22 and we are obligated to sell our stock at that
price. In this case, we recognize a maximum profit of $0.85 a
share -- or a 4% return in a few weeks' time.
Now, let's assume that over the next few days, silver rallies
sharply. In fact, the precious metal surges dramatically so that
SLV is now trading at $26.
In this situation, the $22 calls would immediately trade
higher, likely to a price near $4.10. Why do I say $4.10? Because
option buyers have the right to buy the stock at $22, and they
can then turn around and sell it in the open market for $26,
recognizing a $4 profit. The extra $0.10 would be the remaining
time value of the option.
The option contracts should not trade much higher than $4
because the calls are now deep in the money. (For statistical
reasons, deep in-the-money calls wind up trading very close to
their "intrinsic value" -- the difference between the strike
price and the actual stock price.)
From our perspective as covered call traders, we would now own
stock that is worth $26 per share and be short calls that are
trading at $4.10 per share. With these prices, we already have
$0.75 of profit baked into the position -- with only another
$0.10 of potential profit to go.
More importantly, we have our capital tied up in this trade
for another three to four weeks with little or no new profit
available to us. In my opinion, this is a waste of our trading
capital because we could be earning a return by entering a new
position with more opportunity.
So let's take a look at how we might adjust this position to
continue to make a profit with our capital.
3 Covered Call Adjustment Scenarios
Our decision of how to adjust the position depends on a few
different factors. It is important for us to evaluate how SLV
might trade from this point. We also want to evaluate what kind
of opportunities are available in addition to SLV. And finally,
we need to know just how much capital we have available in our
account for adding new trades.
With this information, we're going to make one of three
|1. Close the Position Outright
|In a target-rich environment where we continue to have
a number of attractive covered call opportunities to
pursue, it may make sense to forgo the last $0.10 of
potential profit in this trade and close out the position.
Keep in mind that if we close out the position (buying
back our calls at $4.10 and selling our stock at $26), we
will only book a profit of $0.75 for the trade. But at the
same time, we will free up our capital to then invest in a
new position that could net us much more over the next few
This is a classic "opportunity cost" equation, where we
give up a small amount of profit ($0.10 in this example)
for the opportunity of booking a much larger profit on a
|2. Transition to a New Strike
|Another option would be to buy back the calls with a
$22 strike price and sell call contracts for a higher
strike price -- giving us more potential gains without
disturbing our stock position.
This approach would make sense if you believed that
silver was still a strong investment opportunity and that
there was a relatively low probability that SLV would back
off. In this case we would buy back the existing calls at a
$4.10 and we may then sell the $26 calls at $0.85. This
would give us another $0.75 in potential profit per
One benefit of this approach is that we are not forced
to sell our stock position and we can use our broker's
"spread trade" functionality to ensure that we get a good
execution for our option trade. Most brokers will let you
enter both sides of the trade (buying the $22 calls and
selling the $26 calls) as a single order with a limit price
for the full transaction.
|3. Add Another Layer to the
|One other option is to add another layer to the trade
-- buying more shares of SLV and selling a new set of calls
against the position.
This approach would make sense if you have plenty of
capital available for the trade (especially if you are
trading with a margin account), and if you are worried
about short-term tax ramifications. We'll talk about the
tax issue in more depth in a future article, but the bottom
line is that you could buy more shares of SLV at $26, sell
the $26 calls at $0.85, and then later determine which lot
of stock you want to exercise against the original $22
This approach gives you more flexibility and still
allows you to capture another block of profit as SLV
continues to trade higher.
Action to Take -->
As with most profitable trading strategies, there is a level of
simplicity that allows for healthy, predictable profits, and then
another level with a bit more complexity that allows for even
stronger profit potential.
This article was originally published at
Adjusting Your Covered Call Positions for