Options Coach: Repairing a Broken Covered Call

Writing covered calls -- selling an out-of-the-money call against shares of a stock that you own in your portfolio -- can be a great way to generate a little extra income. A covered call strategy is perfect for stocks that are stagnating in a sideways channel; that is, the equity isn't yet meeting your long-term hopes, but you still maintain a bullish outlook for it. The hope is that the stock will remain below the sold strike through expiration so that you will retain the premium.

The typical covered call writer is looking for extra income to either help lower his stock's purchase price, increase his yield on holding the stock, or act as a downside buffer. In a down move, the premium will act as a cushion and will provide some flexibility by lowering the breakeven price of the stock purchase.

However, what do you do if you've written a covered call on a particularly volatile stock, and find that the the stock price moves well beyond the written call strike? This can be frustrating to the covered call writer, who has been able to collect premium and enjoy the upside move, but is unable to reap any further profits beyond the call strike. Are there repair strategies to recover at least some of these profits without actually buying back the covered calls? You betcha.

So what can you do?

First, plan for a variety of contingencies beforehand. Before you enter a trade, you should predetermine at what levels you are willing to make adjustments to your position if the market reaches a certain point. This should include both upside and downside moves .

Once you are in a trade, it's usually too late to think about what you should have done to prevent a disaster or a missed opportunity. Rational thinking too often leaves the room during the heat of battle. Therefore, plan ahead, and stick to your plan.

When writing a covered call against a highly volatile stock, you have to be able to make decisions quickly.

For example, let's assume that you purchase a stock at 164 and sell the 200 call against it. What if the stock moves quickly to 200? The key to improving this trade is maintaining exposure to a winning stock. One of the easiest ways to maintain exposure to the upside is to purchase a higher strike call. For instance, you could purchase a 220 call. If the stock has risen enough, the cost of this call may be close to the premium you received initially. In essence, your call prices "wash out."

Another strategy you could use against your one short call at 200 would be to buy two 220 calls and sell one 240 call. Essentially, you've just entered into a short butterfly spread.

In summary, you can look vertically, horizontally, or diagonally for some help. By this we mean look either to a call that is vertical, horizontal, or diagonal from your written call for help.

Vertically would be an option that is above or below your written call's strike price. An example would be if you were short a 190 call, look to trade a 170 or a 210 call for help.

A horizontal play would involve looking at a call with a different expiration period but same strike, e.g., a May 190 call versus a June 190 call.

A diagonal trade would involve a different strike and a different expiration - a June 210 call versus a short May 190 call.

Schaeffer's Investment Research Inc. offers real-time option trading services, as well as daily, weekly and monthly newsletters. Please click here to sign up for free newsletters. The SchaeffersResearch.com website provides financial news, education and commentary, plus stock screeners, filters and many other tools. Founder Bernie Schaeffer is the author of the groundbreaking book, The Option Advisor: Wealth-Building Techniques Using Equity & Index Options .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

All Rights Reserved. Unauthorized reproduction of any SIR publication is strictly prohibited.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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