August 11, 2004

When to close a covered call position
by John Brasher, CallWriter Publisher

The simplest way of trading covered calls is just to write them and let them go to expiration. This is the easiest strategy and probably the one most covered call writers use. However, covered calls frequently present the opportunity to get out of the trade early for great profits or to minimize a potential loss. While it is by no means always necessary to close a covered call position before expiration of the calls sold, there are several situations that call for an early close.

The Four Exits

Covered call writers, like all traders, should enter a trade with a reasoned trading plan. Specifically, the trader should know the profit being sought and the stop-loss point at which to exit the trade in order to minimize losses in the event the trade goes wrong. There are four instances in which a covered call position should be closed (by repurchasing the calls and selling the stock) instead of letting it go to expiration:

This point presupposes that the trader actually went into the trade with a plan. For example, a covered call trade may upon entry set up a potential profit of 5.5% flat and 10% if called with a 30-day trade duration, but the trader has planned to close the position if a 3.5% profit presents itself in the first two weeks (which would be equivalent to a return of over 7% for 30 days). Many covered call writers plan trades in this manner.

This point may seem like a duplicate of the first one, but it is not. Even the trader who is loath to plan trades and does no more than the basic research and technical analysis before trading should be aware when the trade presents a profitable early exit. The fact is that high covered call premium implies higher than normal volatility. But if the market's expectations concerning a stock should change before expiration, the implied volatility will collapse. For this reason, it frequently is possible to exit a trade early with a nice profit.

Not every trade presents an acceptable early exit, and even those that do will not always present a profit that is as high as the profit expected if the trade goes to expiration. However, exiting the position terminates trade risk, locks in a profit, and frees the trader's funds for other trades. How much profit is enough? That depends on the trader's viewpoint. Besides, keep the profit proportions in mind. For example, if a trade with an expected duration of 30 days sets up a 5% profit and it is possible to close it for a 2.8% profit after 10 days, this works out to an 8.4% profit for 30 days. In other words, to calculate the real return, you must match the return to the trade duration.

For those traders who ask us if they should always be watching stock and call prices on open trades, we firmly believe that every position should be looked at at least a few times daily. This is partly to watch for an adverse move in the stock and partly to be aware of opportunities for a profitable early close.

Note: Sometimes it is better to close the short call only instead of the entire position, meaning to buy back the calls sold but not sell the stock. This is the case where the stock is showing technical strength and you expect it to go up, and the call can be bought back at a profit. Some covered call writers make it a habit to close out calls when they can be bought back for 25% of the premium received. If the stock has not dropped correspondingly with the call premium, this is always a profitable maneuver.

Premiums on ITM calls have two value components: the part that is in the money (below the stock's price) is known as intrinsic value, and the part of the premium that is above the stock price and not in the money is known as the time value. At-the-money and out-of-the-money call premiums are all time value, of course. On every option sold, the profit is all in the time value. For this reason, it is highly unusual for options to be exercised before expiration when there is any time value left. However, when the time value disappears, ITM calls can be exercised at any time, and the covered call writer is in danger of assignment and losing the shares.

For example, if you buy a stock for $16 and write an ITM 15 Call for a $1.50 premium, then $1.00 of the premium is intrinsic value and $0.50 is time value. If the premium drops to $1.00, all of the time value has evaporated, which means the calls might be exercised at any time. If the calls begin trading at a discount, meaning less than intrinsic value, the danger of early assignment rises dramatically.

We firmly believe that every trade has to be entered knowing the stop-loss point - -that is, the point at which the trader will close the trade if the stock drops far enough. No two traders will necessarily set the stop loss at the same price, but trading discipline dictates that the worst case be planned for. Ideally, the stop-loss point will be above the trade's breakeven point, so that it can be closed without a loss or only a very small loss. While there is not room in this article to thoroughly discuss the stop-loss point, we are believers in not closing trades until a support level has been violated, because stock prices oscillate, and a stock can pull back to the breakeven point and recover just fine. For this reason, the place for effective stops in our experience is right below support. Support can be a trend line, 50-day moving average or traditional support level.But the important point is to have a stop loss set when the trade is run, whether the stop is a mental one or a trade order. If you are not in a position to watch the trade, it is better to enter a stop order with your broker just in case the stock drops unexpectedly.

Note: An alternative to closing the position when the stock has dropped to the stop loss point or close to it is to buy back the short call and sell a deeper ITM call, which is known as rolling the call down. Although in this instance the stock has dropped, the trader usually picks up a profit on buying back the call. The sale of the deeper ITM call brings in more premium, which gives much more downside protection and lowers the trade's breakeven point. You have to do the math on each trade to see if rolling down makes sense in a given instance.

A sell stop order on a covered call position usually must be entered as an OTO (one triggers other) order, in which the position is closed – that is, the stock sold and short calls bought back – when the stock hits the trigger, or stop price. Not all brokers allow this, so check with your broker if it offers an OTO or contingent order that will accomplish the goal, and be sure you understand how it must be entered.

Doing the Math

CallWriter members can easily do the profit and loss calculations discussed above, using CallWriter's proprietary Position Management Calculator™, which shows the trader in an instant whether there is more profit in staying in a position, closing it or rolling to a different call. To see how our calculator works, click here. Persons who are not CallWriter members can do the same calculations manually, of course, but they will be a bit more laborious.

Below is a simple calculation table for covered calls. The first two columns reflect trade entry. In our example, the traders buys XYZ stock for $15.20 and sells the in-the-money 15 Calls on it for a $0.70 premium, which sets up a potential profit of 3.29% at expiration, assuming the stock is called away. However, a week after the trade is run, XYZ's implied volatility collapses, and the premium drops even as the stock goes up in price. The last two columns reflect the results of closing the trade. It is possible to buy the short calls back for only $0.30 and to sell the stock for $15.60, generating a higher than anticipated profit of 5.26% for a one-week trade - which works out to more than a 20% return for a month.

Trade costs have been omitted for simplicity's sake, but they can easily be taken into account. One doing these calculations without our calculator should be sure to calculate profit only on the time value portion of the premium on in-the-money calls.

Good luck and good trading!