Monthly Archives: March 2013

Covered Calls ~ Managing the Trade

If you’re thinking about using covered calls for income, you’ll want to consider how you’re going to manage your trades from the time you establish them until option expiration.

If you already hold the underlying stock or ETF, you’ll it’s only a matter of selecting the strike price and expiration of the call option that you wish to sell and entering your order. When you enter the order you are faced with the decision of what order type to use. When selling calls most traders will choose between a market and a limit order. You may have read elsewhere that you should only use a limit order when trading options. I don’t agree with that and have found that I get excellent executions with market orders as long as the stock is a very liquid penny pilot issue. The most liquid ETFs have excellent execution on market orders and there are times when a market order is better, such as a rapidly falling price, where you’d if your limit wasn’t going to get hit, you’d have to go through the process of canceling and replacing and if the underlying has fallen you’ll have to settle for a lower price than you would have with a market order. If the stock or ETF that you’re selling the call option on is not very liquid and has wide bid ask spreads, don’t use a market order, use a limit and place it about halfway between the bid and the ask then give it time to get filled. The thinner the trading is, the more patient you have to be with the order getting filled.

If you don’t already own the position in the underlying you have some more choices. One choice is to sell a cash secured put, then wait until you get assigned and begin the call writing process. Another choice is to use a buy write ticket. With a buy-write ticket, you enter a simultaneous order to buy the stock and sell the call option at a net debit. So, if the stock is trading at $25 and the option is selling for $1, you’d enter an order for a net debit of $24. You can also use market orders with buy-write tickets and they’ll work as long as the underlying is very liquid. If the underlying is not very liquid and has wide spreads, use a limit order for sure.  If you don’t want to use a buy write, then first you purchase the underlying security, then sell the call option. If you like to trade a little bit, to try to enhance returns, you can leg into the position, by buying the stock, letting it run up, and then selling the call if the stock begins to drop.

Once you have a covered call position established two things can happen at expiration, either the price of the underlying is above or below the strike price, you either get called or the option expires worthless. If you’re option is in the money prior to expiration and you decide you want to keep the stock, you’ll have to buy the calls back, then sell more at another expiration date. If you roll the calls for a credit, that is you sell them to open for more than you bought to close, you can keep rolling them until they expire worthless and generate a profit. You’ll also need to watch out for your dividend ex-dates. If your option is in the money prior to the ex-date and the expiration date is close by, there is a very high probability that you’ll get called. If you want to hold the stock and collect the dividend, you’ll need to roll for a credit prior to the dividend ex-date instead of waiting for the expiration date. If you decide you want to sell the stock prior to the call option expiring you’ll probably want to buy the option back, and then sell the stock. Depending on your level of option approval at your brokerage, you may have to buy the call back first. If your approval level is high enough for naked calls you’ll need to consider if you want to assume the risk of an uncovered call position.

Have a follow up plan in place before you open the position. Know your dividend dates and manage your positions accordingly.