One of the benefits of the covered call strategy is that it is usually a "set and forget" type of approach. By that, I mean that we can set up our positions (buying stocks and selling call options), and then wait until the option contracts expire to make any adjustments.
While the majority of covered call positions are held until maturity, there are certain times when it makes sense to adjust a position before the options expire in order to reduce risk or to capture an even bigger profit.
We've previously covered adjustments to covered call positions for the purpose of risk management. Today, I want to focus on adjustments to covered call positions that move dramatically in our favor. In these situations, the objective is to maximize our profit and make the most efficient use of our capital.
Anatomy Of An Accelerated Covered Call Position
To understand both why and how to take advantage of a covered call position that moves sharply in our favor, let's set up a hypothetical trade to see exactly how the different components of the trade work together.
For our example, let's assume we are buying the iShares Silver Trust (NYSE: SLV) and selling call contracts against the position. (Remember, this is an example, not a recommendation.)
-- Buy SLV in 100-share lots at $21.85
-- Sell calls contract that expire in one month with a $22 strike price at $0.70
-- Net cost: $21.15
With this trade, the best-case scenario for us is that SLV trades above $22 and we are obligated to sell our stock at that price. In this case, we recognize a maximum profit of $0.85 a share -- or a 4% return in a few weeks' time.[More from StreetAuthority.com: When Is Risk Your Ally In Income Trades?]
Now, let's assume that over the next few days, silver rallies sharply. In fact, the precious metal surges dramatically so that SLV is now trading at $26.
In this situation, the $22 calls would immediately trade higher, likely to a price near $4.10. Why do I say $4.10? Because option buyers have the right to buy the stock at $22, and they can then turn around and sell it in the open market for $26, recognizing a $4 profit. The extra $0.10 would be the remaining time value of the option.
The option contracts should not trade much higher than $4 because the calls are now deep in the money. (For statistical reasons, deep in-the-money calls wind up trading very close to their "intrinsic value" -- the difference between the strike price and the actual stock price.)
From our perspective as covered call traders, we would now own stock that is worth $26 per share and be short calls that are trading at $4.10 per share. With these prices, we already have $0.75 of profit baked into the position -- with only another $0.10 of potential profit to go.
More importantly, we have our capital tied up in this trade for another three to four weeks with little or no new profit available to us. In my opinion, this is a waste of our trading capital because we could be earning a return by entering a new position with more opportunity.
So let's take a look at how we might adjust this position to continue to make a profit with our capital.[More from StreetAuthority.com: The Best Way To Profit From This Beaten-Down Sector's Rebound]
3 Covered Call Adjustment Scenarios
Our decision of how to adjust the position depends on a few different factors. It is important for us to evaluate how SLV might trade from this point. We also want to evaluate what kind of opportunities are available in addition to SLV. And finally, we need to know just how much capital we have available in our account for adding new trades.
With this information, we're going to make one of three possible adjustments:
|1. Close the Position Outright|
|In a target-rich environment where we continue to have a number of attractive covered call opportunities to pursue, it may make sense to forgo the last $0.10 of potential profit in this trade and close out the position.
Keep in mind that if we close out the position (buying back our calls at $4.10 and selling our stock at $26), we will only book a profit of $0.75 for the trade. But at the same time, we will free up our capital to then invest in a new position that could net us much more over the next few weeks.
This is a classic "opportunity cost" equation, where we give up a small amount of profit ($0.10 in this example) for the opportunity of booking a much larger profit on a new trade.
|2. Transition to a New Strike Price|
|Another option would be to buy back the calls with a $22 strike price and sell call contracts for a higher strike price -- giving us more potential gains without disturbing our stock position.
This approach would make sense if you believed that silver was still a strong investment opportunity and that there was a relatively low probability that SLV would back off. In this case we would buy back the existing calls at a $4.10 and we may then sell the $26 calls at $0.85. This would give us another $0.75 in potential profit per share.
One benefit of this approach is that we are not forced to sell our stock position and we can use our broker's "spread trade" functionality to ensure that we get a good execution for our option trade. Most brokers will let you enter both sides of the trade (buying the $22 calls and selling the $26 calls) as a single order with a limit price for the full transaction.
|3. Add Another Layer to the Position|
|One other option is to add another layer to the trade -- buying more shares of SLV and selling a new set of calls against the position.
This approach would make sense if you have plenty of capital available for the trade (especially if you are trading with a margin account), and if you are worried about short-term tax ramifications. We'll talk about the tax issue in more depth in a future article, but the bottom line is that you could buy more shares of SLV at $26, sell the $26 calls at $0.85, and then later determine which lot of stock you want to exercise against the original $22 calls.
This approach gives you more flexibility and still allows you to capture another block of profit as SLV continues to trade higher.
Action to Take --> As with most profitable trading strategies, there is a level of simplicity that allows for healthy, predictable profits, and then another level with a bit more complexity that allows for even stronger profit potential.
This article was originally published at ProfitableTrading.com:
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