You’ve got your prized covered call setup, and it’s working in your account – now what? How do you manage or adjust the position in different market scenarios? Lucky for you, we are going to review the best-covered call management techniques on today’s podcast. If you think this show is just for stock traders, you’d be wrong. Because proper covered call management could be a lifesaver for options traders who get assigned and are forced to deal with stock.
For additional background on covered calls, review Show 171: Covered Calls – Top 3 Performance Insights From New Research and Show 172: Mastering Covered Calls.
Scenario 1: The stock rises.
The best possible scenario: the stock rises and goes beyond your short call strike.
- Option 1: let the option contract assign your stock away (do nothing).
- Option 2: roll-up. With regard to the do-nothing approach, people often ask, “Why not roll up the position if the stock is rallying?”
- Why roll up? Let’s say we have a stock that’s trading at $100. We buy the stock at $100, and we sell the $110 call option to create the covered call. If the stock starts rallying and now your $110 is getting closer, why would you want to roll that contract up? While you’d be giving the stock more room to run, you’re reducing the amount of premium that you collected on the position.
- Option 3: roll up and out to the next expiration month.
- Ask yourself why you would do that if you’re doing it for a debit? That is simply paying to maintain the position.
- If you’ve taken a net credit on that roll, it is okay. You’re giving the market more time to challenge your position, and you should get compensated for that additional time.
The second best scenario: the stock rises but does not reach your strike price.
- This is great for the options trader.
- There is only one option: do nothing and keep all the additional premium.
- You let the call option expire, and then you come back around the next month or your next cycle and sell another covered call option.
Scenario 2: The stock is trading sideways.
- Option 1: do nothing. You sell the covered call, cap some of the upside potential in the stock position in exchange for reducing the cost basis in the shares, and collect the premium from the covered call.
- Option 2: roll down the call option. It’s a simple technique for managing the covered call position. You’re exchanging the higher strike price short call option and moving that strike price closer for an additional credit (in our example, we close the $110 and we reopen the $105). The purpose of the roll is the additional credit then moves your break-even point down by that additional amount.
- Do it later in the cycle, though. Give the market time to go through all the gyrations and cyclicality that it will inevitably go through.
- Option 3: roll out the call option to the next month and give yourself enough time for the stock to move. Punt your current covered call, hopefully for some profit out to the next month, and give yourself more time to let the stock recover.
- This can be combined with rolling down.
- Remember to be aware of the nuances in moving out the contract. If you move from the front weekly contract that’s going to expire soon out to the next monthly contract, they’re not going to behave the same. They don’t decay at the same pace. The front weekly contract is going to decay much faster than if you roll it out.
Scenario 3: The stock goes down.
- Option 1: do nothing. This might not be the best idea because if the stock goes down in a meaningful way, there are things you could do to reduce the cost basis even more, even if it’s just by a little bit. Because all of those little additional credits that you collect by rolling down contracts or making adjustments help at the end.
- Option 2: roll down your call option to something lower. At this point, it’s not about making money anymore, it’s about reducing cost and reducing risk.
- Option 3: roll down and out. Keep in mind that rolling out to the next expiration, even if it collects the additional premium, is going to behave slower. Our preferences is to make an aggressive adjustment in the current month, even if temporarily for the next 15 days because, if the stock starts to recover, you can roll out and up and reset everything for the next month. For that time period, it’s not clear if the stock is going to recover.
- Option 4: the collar strategy. Use the premium from selling the covered call to temporarily buy protection on the put side. This is like an on/off switch: it costs money to buy the insurance and protect the position, but that’s what you want it for. You turn it on if you want the protection and then you turn it off if you don’t. This helps to reduce the risk of the stock going down lower.
- When the stock rises: you can do nothing, or you can roll up, but again the question is, “why?” You can also roll up and out, but only for a credit.
- If the stock trades sideways: you can do nothing, roll down your calls, or roll them out at the same strike price.
- If the stock goes down: you can choose to do nothing, which is not the best option. You can roll down aggressively, you can roll down and out, or you could use the premium from the call option to buy put protection and create a collar.
Option Trader Q&A w/ Brian
Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today’s question comes from Brian:
Hey, Kirk. This is Brian again from Illinois. I listen to your daily and weekly podcasts. Over the past few weeks, you’ve talked quite a bit about various brokerage platforms and you mainly mention Thinkorswim, Robinhood, and Interactive Brokers. I’m just curious in my albeit comparatively very limited experience – I’ve also had TradeStation come across my computer screen many times from other traders, or from other titles or whatever and they also seem like a pretty competitive brokerage and platform, but you never seem to talk about them. I’m just curious to know your thoughts on TradeStation, since you mentioned Robinhood, Interactive Brokers, and Thinkorswim. Is there a reason for that? Do you have limited experience with TradeStation, or is there something about that platform that you actually discourage people from using it and I just am not aware of that? Thanks.
Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.
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