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.