TSC Options Forum: Covered Calls

Could you give us some insight on what strategies you use in exiting covered call positions that go against you? I am a shareholder in United Parcel Service(UPS Quote) and had to cover the January 65 at a loss today. Even though the positions expire in January, I was fearful that the stock would be called away, because the shares go ex-dividend next week.

Thanks,

-- Paul

While it's hard to game whether Paul's shares would have been called away through an assignment of the short call options, his concerns are legitimate: At Friday's prices, with UPS trading 72.55, the January 65 call is $7.55 in the money but being traded at $7.65, giving it just 10 cents of time premium. With the stock going ex-dividend next Thursday, Nov. 20, someone could choose an early exercise to qualify for the 25-cent quarterly payment.

Even though he already pulled the trigger and prevented the early assignment, we can still take a closer look at his position. Since UPS shares have delivered a 15% price gain (to $74) over the past six weeks, it may seem like writing (selling) calls was a bad decision. But assuming Paul wrote the January 65 calls when UPS was trading below $65, I wouldn't characterize his position as a loser or even as having gone against him.

Even though the short call portion of the position registered a loss as the options went into the money, this would be more than offset by gains in the long stock. Keep in mind that the profit potential of a covered call is limited to the premium sold plus the price differential between the strike price and underlying share price at the time the calls are sold.

As you can see, UPS shares were essentially flat for five months, trading between $62 and $65 from May until October. I'm sure at some point during this time period the idea of selling covered calls seemed like an intelligent and prudent strategy.

Recent Run Leaves Call-Writer Grounded Shares are up 15% in the last six weeks

You Done Good

But even in hindsight, I think it makes perfect sense. Let's assume (on no evidence whatsoever) that Paul waited until Sept. 12, just before the stock started moving up, before selling those January 65 calls. At that point, with UPS shares trading at $62, the calls -- using an implied volatility of 17% -- would have had an estimated value of $1.60 when they were sold. This allows for a maximum profit of $4.60, or 7.5%, which equates to a return of nearly 21% on an annualized basis. That isn't too shabby when you consider that UPS, even with its recent run, is up just 16% this year. A good rule about investing is that once you lay out your plan, don't second-guess yourself.