Close Calls from Covered Call Strategies

How to stay out of trouble when writing covered calls.
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What's with all these covered call questions? It seems like people find more ways to trouble themselves by writing calls against stock than almost any other options strategy.

While one proponent of covered write strategies makes himself heard this week, we hear from two other investors who have had some difficulties after establishing similar positions. In addition, another reader couldn't finish off an in-the-money call trade at expiration and his brokerage firm exacted a pound of flesh for the indiscretion.

So here's one covering the ins and outs of these situations.

Feel free to send any questions along to

optionsforum@thestreet.com, and please include your full name.

Joy of Covered Calls

Would it be appropriate to sell covered calls to close out a long position? Let's say I bought shares of Company X for $40 per share and had a target price of $50. If the price approached $50, why not sell the covered calls for a $2 or $3 premium? If the stock gets called away, you close out your position at the target price, along with the premium. If the stock doesn't hit your target and subsequently is not called away, you keep the premium. If so, why wouldn't everyone close out long positions this way (assuming they don't need to sell the stock ASAP for the capital and can wait for the options to expire)? -- Jim Michaels

Jim,

Sounds easy, doesn't it?

There are many reasons why everyone wouldn't want to write calls against their stock positions. Primarily, the transaction costs or commissions could eat up some gains if you weren't careful, not to mention the fact that writing a call against a long stock position limits your upside.

If you had written 10% out-of-the-money calls against, let's say, a long

eBay

(EBAY) - Get Report

position in November, you would've either missed out on tremendous upside or had to pay out the wazoo to buy the calls back. Neither is a desirable result.

But you are right that if you have some clear parameters and the opinion that a stock most likely won't hit the strike you sold, writing calls can be lucrative and even prudent. This may sound like a cop-out, but the biggest decision is your fundamental opinion on the stock.

Covered Call Crash and Burn

I just needed to vent to someone who could relate. I sold 5 March covered call options on @Home (ATHM) - Get Report with a strike price of 120 on March 17. I collected a measly $800 ($1 5/8). As you may have guessed, @Home rallied in the 48 hours remaining before the options' expiration, and I closed out my position the afternoon of March 19 by buying 5 calls at $14. I also sold my 500-share @Home stock position. What next? You guessed it: @Home is currently around $150. What kind of rules of thumb do you follow for avoiding stupid plays like mine? Mike Kirk

Mike,

We feel your pain. We really do. But one quick question: Why'd you bother to buy the calls back if you were going to sell the shares anyway?

Or, on the other hand, why'd you bother to sell the shares and throw away upside if you were going to buy the calls back?

You may have made a mistake by writing a call with just two days left until expiration. Sure, from one point of view, you're selling something that only has two days to come back and bite you. It's almost free money. Almost.

The other side of that coin is that all of the time value has been taken out of the option's price, so you were selling it at possibly the worst time. (That explains the "measly" return.)

If you would have sold the April calls instead, the premium you collected would have been greater (because there was more time value in the option) and you could have given yourself a little more time to decide on something.

We ran your situation past our guy at the

Options Institute

, John Power. Essentially, when you write calls, you have to be of the opinion that you like a stock, but don't love it, he warns. If it starts to run, you may fall in love. In that case, you keep the shares and buy back the calls.

In this case, the stock ran so much so quickly that you forgot that a covered call is not a hedge. It is a rate-of-return strategy that you hope will leave you content with collecting premium, lowering your purchase costs and selling the stock at some gain, says Power. "You get a great rate of return but you have to tell other people to keep their rocket ships to the stars," he adds.

Power can't comment on specific stocks, but we can tell you that when writing calls on Internet stocks, you should expect this kind of volatility. Your problem even afflicted the pros last year when

Amazon.com

(AMZN) - Get Report

was putting in those 35-point gains. Many floor guys were short the calls and ended up barely able to hedge their positions.

Dollars and Common Sense

I've just started using the buy/write or covered call strategy. I've read Courtney Smith's

Option Strategies

and a couple of other books, but nothing beats a dollars-and-cents education. I understand that a buy/write limits your upside (unless you buy your call back at a higher price) and leaves the bottom wide open. And if the stock stays close to flat or at least below your short call's strike, you still win. You get to keep the premium and your stock. But when a stock gets hit suddenly by a downgrade or something unexpected and I'm at break-even, I'm getting conflicting advice. One source says buy your original calls back on the cheap at the time of the event and sell a new set short, lowering your break-even again. The other says punt, liquidate the position. I'm a month from expiration, this stock is volatile anyway, but has been trending somewhat sideways. I'm undecided more because I don't know if a month is enough time to recover from a downgrade. What do you think? Roll down or take my ball and go home? -- Russ Miller

Russ,

There's no ideal answer to your situation.

You could let the call you sold expire worthless. There's little reason to buy it back unless you think there's a chance of a run-up. Whether an option expires worthless by $2 or by $12 doesn't really make a difference. Buying it back, however, ensures that you're not open to that risk.

You should be selling options that are at or out of the money if they are near-term contracts. If they go further out, you shouldn't get yourself too deep in the money because, naturally, there's a better likelihood you'll be assigned.

As far as reestablishing a position, that's a different story. You probably want to wait a little to see what type of trading pattern the stock takes and where its new range lies. Don't do things automatically, because with volatile stocks, there's not enough stability to venture an educated prediction.

Expiration Squeeze

I really need some help regarding options expirations. On Friday, two calls for the same security expired in the money (by 9 points). I did not have money in my account to buy 200 shares. So, 100 shares were assigned to me (via my margin account) and the brokerage (a discounter) kept the proceeds ($900) from the second option. I called them and they said, "Sorry, that's our policy." Is this legal? Do I have any recourse? -- Bob Rezzarday

Bob,

Quite a pickle, no?

First, let us chastise you a bit for owning an option nine bucks in the money at expiration and not closing it out.

Now, to the specifics of your situation. There may be details in your question you've left out for the sake of brevity, but essentially your brokerage clipped you for trying to get what it calls a "free ride." That term refers to a trade in which you never deliver the funds to complete an options exercise.

We spoke with one compliance expert at a major retail firm, and he said the brokerage should have made every effort to contact you to come in with the capital to exercise the options. If it did and you didn't take that opportunity, then bang, the firm does the trade (buys the shares with its capital and then sells them) and as a result feels entitled to the proceeds. Those proceeds would not have been realized without the firm's capital.

Here's a little expiration background for the next time you find yourself in this situation.

All options that are more than 3/4 in the money at expiration are exercised. This doesn't mean that all the options positions are sold, or that you're able to do a trade without having adequate capital.

On expiration Friday, unless you were on a gurney, you should have either exercised the contracts and then sold the shares, or just sold the options. The latter would be the better choice when you consider you'd only be paying one commission as opposed to three. But either way, until 4 p.m. Friday, it was your choice.

It may sound harsh, but your failure to act put that choice in the hands of the brokerage firm. Your only grounds for action could be if the firm did not give you adequate time to respond to its request for direction or capital.

If there are any details that could help us get a better handle on the situation for you, please send them along.