For instance, if I own a stock that’s selling for $33 per share, I’ll sell calls at $35 or higher. Therefore if the stock is called, I keep the option money and I make the difference between the share price and the call price which in this case is $2. My loss is the potential gain I would have made if I had kept the stock as it rose above the $35 strike price. In this case I made a profit (the fee I received for selling the option as well as the $2 in stock appreciation) but not as much as I could have made if I had only held onto the stock and not sold the option. It’s this balance of receiving the upfront option income versus the possible loss of potential income that is the trade-off I am making.
In the example above I could have sold options with a strike price of $40 and decreased the probability of having the stock called away, but I would also have decreased the amount of upfront income from selling the call option. I could have also sold options with a strike price of $30 but this is considered an “in the money” call and the probability of the stock being taken away is significantly higher because the actual price is above the strike price. The current income, however, would be greatly enhanced because I am expected to lose the stock at a loss. This decision to accept an increase in upfront option income would have to be balanced against selling the stock at a loss (currently at $33 and selling a call for $30 would result in a $3 loss). This is not an optimal strategy unless I expected the stock to fall below the strike price of $30 before the option expiration and the option would expire worthless. But if I really expected the stock to fall below $30 I wouldn’t execute this strategy. I would rather sell the stock at $33 and subsequently buy it back at a price below $30 once it fell. I sell covered calls for the sole purpose of generating monthly or weekly income and not for the purpose of intentionally having the stock called. If I no longer want to own a stock, I simply sell it and the position is gone. I don’t use covered calls as an exit strategy.
If I bought a stock for all the right reasons (increasing revenues, earnings and dividends) and mistakenly sold covered options when the stock was moving up at a rate that it climbed through the strike price prior to expiration, I have two options available to me. One option is to buy the option back at a loss and keep the stock and the second is to simply let the stock go. In these cases my decision is always to let the stock go. I keep the option income and the increase in stock price and let the stock be called.
If I’m still interested in the stock after it’s called, then I’ll reevaluate the stock as if I was looking at it for the first time. I’ll evaluate it the same way as I evaluate any other stock. And for that I’ll refer you to my posting on ”Finding the Right Stock”.
If it is the right stock and the price is right, then I’ll just buy it and look to sell “out of the money” covered calls once I own it. If it’s the right stock but the price is too high, I’ll look at selling puts. This is a strategy of receiving current income with the possibility of buying the stock at the right price. For this I’ll refer you to another of my blog posts titled “Go Short to Go Long”.
In the opposite case of selling covered puts, I’ll discuss the trade-off between option income and the actual loss of being forced to buy a stock at a price higher than the current quoted price in a future blog post. I also have a strategy I put in place when that happens that attempts to salvage an undesirable situation. And it’s these exit strategies or contingency plans that can be the difference between success and failure for me.