This month’s dastardly volatility attack is shining a light on the protective aspect of covered call writing. In strong up months covered calls cap your profit thereby delivering underperformance and a healthy dose of regret. In down months they’re worth their weight in gold. The premium received spins some protective magic by offsetting the first percent or two of downside in the stock.
For example, say you were long EEM (the go-to ETF for all things emerging markets) at $38 and sold the Oct 38 call against it for $1.00. Though the specter of higher rates has driven EEM into the ground this week, the protection afforded by your short call has been on full display.
To wit: EEM is down $1.86 generating $186 loss on the stock. Meanwhile, the Oct 38 call has fallen to 35 cents. Since you originally shorted the call for a buck its descent to 35 cents has delivered 65 cents of profit per share. That’s $65 total.
In sum, the stock is down $186 while the short call is up $65. The call’s gain is paring your loss by 30% to $121. Not bad!
Now, here’s where today’s lesson comes in.
Some traders look to squeeze every last penny out of their short calls. They ride to expiration every time before selling the next month’s covered call. And while they succeed in maximizing the profit afforded by the call each month, I fear they’re failing to give the protective nature of a short call its due.
When a drop in the stock reduces your short call value to pennies it means you’ve run out of protection. That’s the absolute worst time to see a stock swoon. Incidentally, that’s when my paranoia runs hottest.
This explains why I’m obsessive about snatching back short calls when they’ve lost the bulk of their value. I’m particularly sensitive to this when volatility has been unleashed and is ravaging the land with its loss-inducing claws.
Don’t be afraid to close your short calls quicker than usual and replace them with juicier ones by rolling down or out to the next month. When loss minimization becomes high priority this technique is a must.
Want more covered call enlightenment? Check out these gems:
- Covered Calls: Weekly vs. Monthly
- Theta and Covered Call Management
- Cash Flow Trickery
- Cash Flow Trickery Part Deux
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