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Tales of a Technician: When Covered Calls Move In-The-Money

January 22, 2019

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Traders have all sorts of rules and guidelines for managing covered calls that move in-the-money. But, in the end, the route you choose comes down to your system’s objective. Today I want to compare the methodology on a conventional covered call to that of the Bear Tamer.

Credit for today’s topic selection goes to Mr. Market which just jammed one of the nastiest V-shaped reversals down our collective throats. The wicked whipsaw has no doubt caught many a covered call trader unaware. Because of how swiftly the market moved from oversold to overbought, I suspect many of us have seen the short call portion of our positions move in-the-money.

Short calls move ITM. Whatcha gonna do?

So, what now?

Conventional Covered Calls

Let’s define a conventional covered call as one where you’re systematically selling 0.40 delta calls to milk the high amount of extrinsic value sitting near the at-the-money strike. This is the approach adopted by the Tackle 25 system. Further, we’ll assume we don’t want to be assigned.

Suppose due to this month’s huge rally, your once slightly out-of-the-money call has become a deep-in-the-money call. The rule we might use is to roll the call once the extrinsic value dwindles toward 10 or 20 cents. Essentially we would buy to close the current short call while selling to open a new 0.40 delta call. This allows us to keep the extrinsic value gravy train moving.

It should be noted that by waiting for the extrinsic value to fall towards zero, you won’t be rolling the call until it moves pretty far in-the-money. In delta terms you probably aren’t making the adjustment until your 0.40 delta call moves toward 0.85 or higher.

The Bear Tamer

One of the primary differences between a conventional covered call and the Bear Tamer system outlined in our expertly crafted Bear Market Survival Guide is the purpose of selling calls. With the former, the objective is to capitalize on time decay by selling close-to-the-money calls. Additionally, because 0.40 delta calls possess substantial premium, they provide a modest amount of downside protection on a monthly basis. With the latter, we don’t rely on the call premium for protection. Instead, we own long-term put options. The role of the calls is to simply pay for the puts, thus providing us with free insurance.

For example, if you bought a one-year put for $6, then your per-month cost is 50 cents ($6 / 12). In selling calls we would target receiving about 50 cents a month.

A second important objective is not capping our profit potential on the stock too quickly. Remember, our long put continues to lose as the stock rises. Because of this, we sell closer to 0.10 deltas for the Bear Tamer. Even with selling this far out-of-the-money, there will still be months (about 1 out of 10) where the calls move in-the-money. What do we do then?

IWM Case Study

Back when IWM was around $130, I rolled the virtually worthless Jan calls to the Feb $145 line. And, we promptly ripped to $145. So, late last week I’m sitting on a now in-the-money call with 30 days remaining to expiration. That’s a long time to sit out further profit potential in the stock! Particularly given that my protective put is worth a lot of money and has plenty to lose on further price appreciation.

So, even though there was still a boat load of extrinsic value, I rolled the call up to the $149 strike thereby opening up another $4 of potential appreciation in the stock price.

Here’s the key point. Had this been a traditional covered call, I likely would not have rolled. Instead, I would have remained in the $145 strike to capture additional time decay.


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