Covered Call: What to do when stock falls rapidly

Mark Wolfinger on

Hello.

1) If you have a covered call position and the stock declines rapidly, then you have 2 choices.

The first is to do nothing and hope the stock recovers. That is not usually a satisfactory choice. It is better to take action in an attempt to minimize losses. (Of course, there is a 3rd choice - sell the stock, and buy the call. That way you accept your loss and close the position.)

The alternative is to roll the option position. That involves 2 steps. You buy back the call you sold earlier and sell a new option. There is no single, correct answer to your question: "What call do we write?" When rolling the position you have 2 basic considerations. Do you want to do everything you can to minimize further losses or do you want to give yourself the best opportunity to turn this bad situation into a winner? Each investor must decide that for himself. If you still like the stock and think it will recover, then you sell the option that gives you the better chance to make some money. If you are uncertain, then you choose the plan that provides the most protection against further losses. Let's look at an example:

Assume you bought 200 shares of stock at 49 and sold 2 Jul 50 calls at 1.50. Your net investment is 47.50 per share. Let's assume this company made an unexpected announcement and this stock falls to 43. What can you do?

To give yourself the best chance to earn a profit from this bad situation, buy back your Jul 50 calls and sell a call with a higher strike price and a further expiration date. But, choose an out of the money call. A good choice might be the Oct 45.

To give yourself the best chance to protect your assets and to minimize further losses, buy back the Jul 50 calls and sell an option that carries a large premium. That high premium means cash in your pocket - cash that provides good downside protection. An example might be the Jan 40 calls. Yes, an in the money option with an additional 6 months before it expires. When you sell this call (it's merely an example of what you can choose to sell - there are other choices) you receive a good price - a price that includes $3 of intrinsic value plus 6 months of time value.

2) If the stick runs higher, you are in a much happier situation. My recommendation is to do nothing and wait to collect your profit. Assume the same stock runs from 49 to 54.

If you want to try to earn even more money from this position (with additional risk), then you can buy back the Jul 50 calls, and sell August or October 55 calls. If you are going to make this trade, it is almost always right to sell a call option with a higher strike price, rather than the same strike price.

The problem with this trade is that it is going to cost you cash out of your pocket. Thus, if the stock changes direction and drops in price, the profit you would have earned can easily disappear, leaving you with a loss. The good news is that you may earn even more than your original profit if the stock maintains its higher price. I prefer the safety of taking the profit and NOT rolling. But, each investor must make that choice for himself.

Mark Wolfinger

Mark,

What should we do when the stock is falling rapidly, what call do we write?

And if the move is up should we buy back the call? If we do buy it back, what strike price should we write again? Same as previous call or higher strike price?

Thanx a lot.

(unsigned)

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