QUESTION: How do you mitigate the risk of a large decline in the underlying stock in a covered call position?
ANSWER: The hit-and-run covered call
Covered calls or buy writes are a good way to reduce volatility in equity positions, but a big decline in the underlying stock still will scuttle a covered call position and lead to significant losses. Your loss is mitigated by the short call position, which will create gains as the option price follows the stock downward; but with a delta around .50, you still will take a hit.
So, what can you do about it? For one, you can shorten the time exposure. You can sell an option that has only a few days to live. In other words, you can hit-and-run. To do that, you have to make the right choice of underlying stock and option.
- Select a stock that is at or near the bottom of its recent range. All else being equal, it will have a smaller probability of decline than a stock at or near its recent peak.
- Look for a stock that is sitting at or near recent lows or highs or at the edge of a price gap, as prices tend to find support at these levels.
- Favor lower priced stocks. Options on lower priced stocks tend to be cheaper and trade more actively, reducing the spread between the bid and ask prices. Stay away from thinly traded stocks for the same reason.
- Apply whatever other technical criteria you favor: Moving averages, price momentum or trend analysis.
- Avoid stocks that will announce earnings between now and option expiration. Betting on earnings surprises is another game.
- Look for an option with a premium of $1.50 or more. If you’re going to take the risk, you might as well be paid well for it.
- Stay away from options with light trading volume. The spread between bid and ask prices on thinly traded options can be as much as 100% and too large to overcome.
- Sell the nearest expiration. The longer an option has to live, the more time the underlying stock has to tank. You want an option that is on its death bed: 10 days to expiration is good, three days is better.
- Sell the strike that is at or just out-of-the-money. You’re not going for a small chance at a big kill; you’re after the premium.
That sounds like a tall order as most out-of-the-money option prices drop to a few pennies during their last week of life. But with research you can find candidates for this trade. The first item you need is a list of 25 or so stock/call-option combinations with the highest potential returns. Many brokerage firms and options houses provide this information to their clients.
A good list will show you the stock, several available option expiration months, the strikes for each month, the covered call’s potential percent return and various Greek values. From these, you cull the stock/option combination that meets your criteria.
On April 16, 2012 you could have bought cloud computing company VMware (VMW) for $109 and sold the out-of-the-money April $110 call against it for $3.10. That’s a return of 2.8% for a four-day investment. But VMW was scheduled to announce first-quarter earnings after the close on April 17, eliminating it from our criteria as the potential volatility was, of course, largely responsible for the rich premium.
A better opportunity was biopharmaceutical company Gilead (GILD). On April 16, it could be bought for $46.50 and the April $47 call sold against it for $1.45. The return was a very nice 3.10% (4.20% if the option finishes in-the-money and the stock is called away), and there was no announcement of earnings. GILD unexpectedly announced a successful test of their new Hepatitis C drug at 5:15 a.m. on April 18, and the GILD stock price jumped $7.00.
It is possible to find very-short-term options with relatively low risk and good payouts to execute a hit-and-run covered call. You just have to get your hands on a compendium of high-potential stock/option combinations and do your homework.
Todd Lofton is a past member and floor trader on the Chicago Board of Trade, author of “Getting Started in Futures” (Wiley, 1986) and “Getting Started in Exchange-Traded Funds” (Wiley, 2008). He was a founding publisher and editor of Commodities, now Futures.