One of the great benefits of the covered call strategy is that you can create income from your investment portfolio by essentially "setting and forgetting" each individual trade. Of course, it is always important to monitor all of your positions to ensure that your risk is under control. But for the most part, you can set up a covered call position and then wait until the calls expire before any additional action is needed.
As a quick reminder, the covered call strategy creates regular investment income through the process of buying shares of stock, and then selling corresponding call option contracts for these same shares. By selling the call options, we obligate ourselves to sell the stock at the option's strike price should the stock price rise above this level before the option expires. This caps our potential profits at a pre-determined level, and in return, we receive income from selling the call option, known as premium.
It is important to note that our maximum profit is realized if the stock closes above the strike price when the call option contracts expire. It does not matter how much higher the stock is trading, only that it is above the strike price. We are obligated to sell our stock at the strike price whether it closes $0.02 or $200 above it.
For this reason, when covered call trades are working in our favor, we typically do not close the trades out early, as we do not realize a larger profit simply because the stock is trading at a peak value.
However, there are certain times where it may make sense to go ahead and close out a covered call trade to lock in profits, depending on your particular situation and the environment for the stock or ETF that you are currently trading.
There are essentially two primary situations in which it may make sense to close out a profitable covered call trade early.
1. When the Stock is Vulnerable to a Decline
We have already noted that a successful covered call trade does not add additional profit for advances above and beyond the strike price. But the timing of the trade is still important. If the stock trades significantly above the strike price, it is very likely that the majority of profit that we will receive in the trade is available now, without waiting until the call option is actually exercised.
So if the majority of the potential profit for the trade is available now, we should consider the current reward to risk for the trade as it currently stands. It is possible that there is very little additional reward (or profit) left for us to capture, but there is a risk that the stock will trade back below our strike price. If this happens, we would see our potential profits narrow or even reverse. Therefore, in many cases, an analysis of the reward to risk for the trade would tell us to go ahead and take the profits now rather than waiting for the calls to expire.
2. When You Have Better Opportunities for Capital
A second consideration for taking profits off the table early revolves around the opportunities that you have to create separate income from your investment capital.
Let's assume that you have a handful of covered calls that represent 30% of your capital. These trades have all moved significantly in your favor and your realized gain in these positions is very near the ultimate profit you expect to receive when the calls are eventually exercised. The rest of your capital is fully invested in other long-term positions that you do not want to disturb.
With your capital currently tied up in these trades, you notice that there are three new covered call trades that you could set up right now that offer a very attractive rate of return. Unfortunately, you cannot take advantage of these opportunities for another month because you are waiting for your current covered call positions to mature before you will have free cash to invest.
In this case, it might make sense to close out the profitable covered call trades that you currently hold in your account, even if there is very little risk that they will reverse and sustain losses, simply because they have little additional profit potential and there is a significant amount of profit potential in new trades that you can set up.
A Word About Transaction Costs
One thing to keep in mind when closing out a covered call trade early is that these trades can sometimes have significant transaction costs. Option prices in particular can have a wide bid/ask spread. This is the difference between the bid price (what the market is willing to pay you for an asset) and the ask price (what the market is willing to take for an asset). This is especially true for options that are deep in the money, which are likely the options that you will be buying to close out your covered call position.
So while the current market price for the stock that you own and the call contracts that you have sold may be very attractive, actually executing your closing orders at this market price may turn out to be more difficult than expected. If you receive a less-than-attractive price for closing out the option side of your trade, you may wind up sacrificing more profit from your existing positions, which may impact the net benefit in closing out these trades so that you can enter the new ones with better return potential.
Commission costs are also very important to consider when trading an active strategy like this. Obviously, this approach doesn't have as much activity as a day trading strategy, but the commission costs each time you set up a new covered call transaction can add up. For this reason, it is important to do business with a credible discount broker that has reasonable fees and reliable market access, specifically for option contracts.
The bottom line is that for most profitable covered call positions, it is best to let them ride until expiration. But in certain circumstances it may make sense to close out the trades early to manage risk or free up capital for new opportunities. Always pay attention to transaction costs, and use a limit order when closing out your option contracts.
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(This article originally appeared on ProfitableTrading.com.)
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
