Covered calls: Getting out early

November 11th, 2009 · 2 Comments

One of the things I’ve recently started to do with my covered call trades is to try and exit the position early by trading a little bit of the maximum profit for a reduced risk of losing money.  Between Sept and Oct expiration, I attempted that by setting a limit credit order for each of my positions.  But this month, I’m trying a limit BTC order for just the call option itself.

Trying to fit all the pieces together in regards to covered calls

Trying to fit all the pieces together in regards to covered calls

Why the change?  Well, let’s back up a bit first and explain what I tried last month.  A limit credit order is one of the few ways TradeKing will let me completely liquidate a covered call position using a single order, where that order matches up with something I want to do.  What I’d actually like to do is to place two orders, one to capture a target gain and liquidate, and the other to accept a loss and also liquidate.  The idea underlying both of those trades is to manage risk by limiting losses, a skill that is critical for any trader, through minimizing unnecessary exposure to the market.  In my case, where I can’t watch the market throughout the day due to having a “real” job, the best I think I can do is to enter two orders to represent the two endpoints of the spectrum of possibilities I find acceptable.

However, it turns out TradeKing won’t let me do a OCO (one-cancels-other) order against a covered call as they claim it is too complex to implement in their platform.  So instead, last month I found myself forced to pick one side of the spectrum to cover with an order, and since things looked mostly positive throughout the month, that was a limit credit order.  Which means, my position would liquidate if I could capture at least X dollars in the process.  Last month I set X to be about 100% of the max potential profit for each position, and the trades never got filled — not really a surprise looking back on it.  Note that for the other side (limiting total losses), I’d just have to manually monitor things on a periodic basis and adjust as needed.

Now, in November, where things are looking down across all three positions I’m in, I really want to place orders to cover the other side of the spectrum.   Unfortunately, you can’t use a limit credit order here because you only want the order to be placed should the potential credit drop below a threshold, not should it go above a threshold (it already is above the threshold I’d set!)  Instead, I could try a contingent credit order.  However, at TradeKing the contingency may only be based on one part of the position — either the underlying or the option but not both.  To me, that makes it too easy to trigger at the wrong time, thus causing me to get out too early or to take more losses than I wanted.   Plus, there’s another potential problem too.

That additional problem is that an early dip in the prices of the underlying could trigger a full liquidation when there are multiple weeks left before exercise.  IMO, a better solution would be to BTC (buy-to-close) the option position at minimal cost, say 5 cents, leaving me with a long position in the underlying and a little bit of captured profit on the call option.  Still having the underlying gives me the opportunity to re-evaluate it, where I may find out that the dip isn’t sustained, and I can then resell a new call for even more income in the same month.  On the other hand, my re-evaluation may indicate that I really should sell and I’m back at a full liquidation.   I’m thinking this extra step to full liquidation is well worth the trouble it takes to handle two separate orders.   Especially since it’s trivially easy to enter a BTC on the option as soon as the position is established.

Keep in mind that for the option price to drop to such a low trading value, it means the underlying has decreased in price, the time premium has decayed, or volatility has dropped.  In all but one of those situations, it’s really a good sign that I could buy back the option for $0.05 as it gives the possibility of higher than my targeted maximum profit.   And even when it’s a bad sign, like I said above, I may not think it’s as bad a sign as the market thought, and if the underlying comes out of its dip, I may also find myself with greater profits than originally expected.   So, this type of closeout can easily result in “letting the bulls run.”

Currently, all three of my covered call positions have an open order to BTC the call options for a limit of $0.05.  I’ve seen a few last trade numbers go by that were exactly $0.05, but unfortunately mine weren’t the ones being filled.  We’ll have to wait and see how this works out over the next two weeks.

Tags: Options

2 responses so far ↓

  1. 1 Blogging Banks // 2010.06.15 at 6:04 pm

    What happened to you? I saw that this blog is dead for some time now. I liked the premise of the site. I would appreciate if you return to blogging!

  2. 2 davmp // 2010.07.24 at 5:59 am

    Hi BloggingBanks, I’ve been very busy recently with a move to the UK for work reasons. Things are starting to settle down, and I’m getting back on top of the financial situation, so I’ll be posting again very soon. (Actually, I just posted a note about getting UK bank transactions into Quicken for tracking.)

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