From the June 2013 issue of Futures Magazine • Subscribe!

Rolling covered calls for protection in a falling market

In April, the options strategy focused on rolling calls in a rising market. Here’s another way to use that strategy.

Despite the broader market’s continued climb to new all-time highs, as with any market, a pullback will occur at some point. Or perhaps you own a stock that already is moving lower and you want some protection. Here’s how to use a covered call to help protect your portfolio from the inevitable downturns.  

A covered call is when one call option is sold for every 100 shares of stock an investor holds, and typically is considered for use in markets that are moving moderately higher. The idea is to sell an option with a strike price that an investor believes will safely expire worthless at expiration, thus allowing him to keep the entire option premium.

But what about when the market drops? You can apply the same covered call strategy to offset some, or even all, of the losses from the stock dropping in value. The strategy just has to be used a little differently.

Let’s assume you own stock that is worth $100 currently. The red line in “P/L gut check” illustrates your profit or loss as the stock moves higher or lower. The bottom blue line shows how the P/L changes when you sell a 105 call at a price of $3.00. The stock continues to profit up to the strike price of $105, plus the $3.00 premium, thus giving you $8 of potential profit.

Look what happens if the stock goes down. Instead of immediately losing as the stock drops below $100, the breakeven point for your covered call position is lowered to $97 because of the option premium collected from the sale. To figure the breakeven point, simply subtract the call premium from the stock price.  

In a market that is moving higher, choosing progressively higher strike prices for the call option allows for more upside potential, but does so at the risk of a higher breakeven price.   

If you sell a call option with a strike price closer to where the stock is trading, then the downside breakeven point also moves lower, which helps cushion the blow in a market that is dropping. As shown, by collecting $5 in premium, the breakeven price for the stock is $95 instead of $97.  

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