June 4, 2004

Defensive Covered Call Trade Management
By John Brasher, CallWriter Publisher

Successful covered call trading requires active trade management, especially when the trade does not go well. When the underlying stock in a covered call trade starts to decline, there are several defensive techniques you can use to cover yourself or minimize the loss.

Anyone can write a covered call, but the ability to manage trades to maximize profits and minimize potential loses or prevent a loss all together is what really makes a trader.

There are several approaches:

The Unwind

The Roll Down

Buy back the calls and sell the lower-strike calls. This is known as rolling down. When rolling down, the stock price has declined, but the option premium will have also declined, so the cost to buy the calls back will be less than the amount received from selling them. The objective is to sell calls deeper in the money and get more premium to protect the downside. Rolling down is a tactic you employ only if you like the stock and want to own it.

Go Naked

Sell the stock and go naked the calls. There is no better covered call trade management tool than the ability to write naked calls. That is, when the underlying stock is in trouble, the best defensive technique is to sell the stock and keep the calls, which leaves the calls naked. Selling the stock before it hits your breakeven point is by far the best way to handle a price decline. While naked writing is considered risky, it is in our view less risky than holding a dropping stock! Naked writing is possible only if your account is approved for naked call trading. Not every trader can write naked, since many brokerages don't allow it, or restrict naked writing to the most experienced traders, and almost all of them will impose large account minimums as a precondition to writing naked. If your broker permits this, be sure to put in an order to buy the stock again if it rises to a point that would endanger your naked calls.

The Protective Put

Buy a put which covers or minimizes the potential loss. This is not often feasible, because the economic choices usually are poor. The first choice is whether to buy a put that truly protects, but costs so much it eats up much of the call premium received. The second is whether to buy a put far enough out of the money that it is cheaper but that only protects against a catastrophic loss. However, when a covered write is in trouble, the trader should always look at the possibility of a protective put, since it can sometimes be done very cost-effectively. We have seen the ability to collar a stock (long put and short call both at the same strike) and provide full protection, yet leave a nice return in the trade.

Your analysis of the market and the underlying stock will in part dictate your strategy, as will the relative costs and merits of each possible move. Trade management isn't just about moves you can make; your assessment of the stock should guide your trade decisions, since defensive moves can only help so much against a cratering stock. Be sure to use the CallWriter Position Management Calculator™ to see where the most money is in regard to unwinding or rolling the calls.

Good luck and good trading!