11 Minute Read

Options Theory: Managing a Short Call when it Moves ITM

June 3, 2021

By | No Comments

You’re neutral to mildly bullish on a stock and deploy a bull call diagonal spread (aka poor boy’s covered call). It is both positive theta and positive delta. The positive theta part makes it what we call a cash flow trade. Furthermore, it will remain a cash flow trade regardless of if you end up profiting off the short call or not. I would caution you against obsessing over whether the short call ends up with a gain or loss. What matters is if the overall position is profitable. More on that in a minute.

If the stock moves sideways or down a little, the management of the short call is relatively simple. Most traders ride the trade to expiration and let the call expire worthless. Or, they buy it back once they capture the majority of the profit. For instance, if I originally shorted a call for $1.00, then I would repurchase it around 10 to 20 cents.

Where things get tricky for new traders is when the short call moves in-the-money. What then? Let’s break down a few key points.

First, this is a good thing. Indeed, I root for the stock to rise enough to push the call ITM, because it means I’m making a profit on the overall position. Consider the risk graph below which models an XLE bull call diagonal where we purchase the July $50 call and sell the June $55 call. Let’s say when XLE was around $52, we entered for $3.20.

$XLE bull call diagonal risk graph

With the stock pushing to $55.38, the short call has moved ITM, and the bull call diagonal spread value has grown to $4.26 resulting in an unrealized gain of $1.06 per share, or $106 per contract. Whether the short $55 call value is now higher than what I sold it for is irrelevant.

My management at this point relies on one of two factors: time value and directional bias.

Time Value

Note in the graph how my max gain is $187. The current gain is only $106. So, there’s another $82 of potential profit – even if the stock goes sideways. This $82 represents the remaining time value in the position. Since it’s so large, I’m incentivized to remain in the position until I’ve captured more of it. This will be a function of either time passing (i.e., riding closer to expiration) or the stock price rising.

My preferred method of management when I’m swinging normal covered calls or diagonals is to use time value. When there’s little remaining, I exit or roll to a new call with more. The primary reason for basing my decision on time is that it’s predictable. Stock price movement, on the other hand, is not.

Directional Bias

The one exception to waiting for time to bleed out is if your outlook on the stock has shifted more bullish. Some traders might opt to roll up the call well before the time value runs out to open up more potential upside. I would typically time this with a breakout or some technical signal.

I try to build my diagonals with enough potential profit that I’m not getting anxious to roll up. In the case study trade above, my max gain was $187 on a $320 investment which is well north of a 50% return. With a gain that high, I’m far less concerned with rolling up the short call than if I was making a smaller return.

Read more Options Theory [FREE Content]

Every Thursday our resident options addict, Tyler Craig, will be at the helm to help you demystify derivatives and better understand what truly makes them tick. Options for beginners? Come this way, please. Enlightenment awaits.

Tackle Trading: Financial Freedom is a Journey. Sign up now for a 15-day free trial.

Financial freedom is a journey

Sign up now and gain unfettered access to all of the quality content and powerful Scouting Reports that our Pro Members enjoy for 15-days absolutely free with no strings attached and let us show you what your trading has been missing.

Legal Disclaimer

Tackle Trading LLC (“Tackle Trading”) is providing this website and any related materials, including newsletters, blog posts, videos, social media postings and any other communications (collectively, the “Materials”) on an “as-is” basis. This means that although Tackle Trading strives to make the information accurate, thorough and current, neither Tackle Trading nor the author(s) of the Materials or the moderators guarantee or warrant the Materials or accept liability for any damage, loss or expense arising from the use of the Materials, whether based in tort, contract, or otherwise. Tackle Trading is providing the Materials for educational purposes only. We are not providing legal, accounting, or financial advisory services, and this is not a solicitation or recommendation to buy or sell any stocks, options, or other financial instruments or investments. Examples that address specific assets, stocks, options or other financial instrument transactions are for illustrative purposes only and are not intended to represent specific trades or transactions that we have conducted. In fact, for the purpose of illustration, we may use examples that are different from or contrary to transactions we have conducted or positions we hold. Furthermore, this website and any information or training herein are not intended as a solicitation for any future relationship, business or otherwise, between the users and the moderators. No express or implied warranties are being made with respect to these services and products. By using the Materials, each user agrees to indemnify and hold Tackle Trading harmless from all losses, expenses and costs, including reasonable attorneys’ fees, arising out of or resulting from user’s use of the Materials. In no event shall Tackle Trading or the author(s) or moderators be liable for any direct, special, consequential or incidental damages arising out of or related to the Materials. If this limitation on damages is not enforceable in some states, the total amount of Tackle Trading’s liability to the user or others shall not exceed the amount paid by the user for such Materials.

All investing and trading in the securities market involves a high degree of risk. Any decisions to place trades in the financial markets, including trading in stocks, options or other financial instruments, is a personal decision that should only be made after conducting thorough independent research, including a personal risk and financial assessment, and prior consultation with the user’s investment, legal, tax and accounting advisers, to determine whether such trading or investment is appropriate for that user.

Chart Modal

Tackle Trading

Book a FREE Consultation

Sign up for a free consultation to build your Educational Plan.