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Options Theory: Managing a Short Call when it Moves ITM

June 3, 2021

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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.

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.

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