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.
Let’s say you bought a stock for $125 and sold a 130 call for $2.00. Now both the stock and the call option are lower in value and your short-term outlook is bearish. It’s time to roll over.
If you have a covered call where the option you’ve sold has dropped in value by a substantial amount, you might decide that it’s time to buy that option to close it out, and then sell another call to re-establish your covered call position and bring in more premium. This is called “rolling.”
With the stock now at $120, buying the 130 calls to close for $1.15 and selling the 120 calls to open at $4.30 (using a short vertical spread), you’ll roll the covered call lower and take in an additional $3.15 of premium that gets added to the premium from the opening 130 call sale. This continues to lower the breakeven point of the trade.
As expiration nears, with the stock dropping to $113, the short covered call can be rolled “out and down”...out in time by one expiration, and down one strike to the 115 call. Using a short “diagonal” order, you can adjust this covered call for a credit of $5.70.
In this example you take in $10.95 in option premium, lower your breakeven level by the same amount, and offset most of your $12 loss in the stock.
By lowering the breakeven point of your stock, we see that covered calls can be used not only for income generation, but also for added protection when markets turn south. By selling lower and lower strikes, you’ll continue to lower your breakeven level. When you think your stock has bottomed, then go back to your “normal” use of the strategy by selling options further out-of-the-money than where the stock is trading.
Greg Loehr is a former CBOE market maker trained by Susquehanna Intl. Group, and founder of education firm OptionsBuzz.com. He has written and presented extensively on options globally.