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) - Get Report 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.
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
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.
When entering a covered call position, ask yourself if you're willing to sell long shares should the calls go into the money, and whether that strike price will yield satisfactory gains. For Paul, or for anyone who wants to continue owning the underlying shares, adjusting the covered call position through the process of
rolling is an appropriate response to calls that move into the money. This involves buying back the calls that were originally sold short, while simultaneously initiating a new short sale on calls with a higher strike price. In this case, you could buy the short January 65 calls and sell the same amount of January 80 calls, and, in effect, extend the life of the covered call by selling an option with a later expiration date.
Here's a question in a similar vein:
I'd like your advice on the following: I wrote covered calls (January 05 LEAPs) on Dell Computer (DELL) - Get Report, which are now underwater ($27.50 strike price!). I would like to sell the stock sometime next spring. How do I get the most money for my shares? I could buy back the options at a loss, but then what should I replace them with to get the most profit when I sell the stock? Thanks, -- L.P.
The term "underwater" usually refers to employee stock options whose exercise (strike) price is below the current share price, making them, for practical purposes, worthless. When an exchange-traded call's strike price is below the share price, it's considered to be in the money, and it has intrinsic value equal to the share price minus the strike price.
Not to give short shrift to L.P.'s dilemma, but I'd suggest he read this
previous column on covered calls (which actually uses Dell as an example) that deals with choosing the most appropriate option, in terms of both strike price and expiration date, for achieving specific goals. The upshot is that selling at-the-money calls of the nearest expiration month will yield the highest return. The risk of this approach is a higher probability of needing to make further adjustments. More trading activity leads not only to more commission costs but also to the increased likelihood of making an error in market judgment.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to