To remind you, this trade involves holding at least 100 shares of a company’s stock, then selling call options against them (one options contract for every 100 shares you own). If the underlying stock declines, you’ll begin to see the option’s premium erode, too. But depending on the timeframe of the trade, you may see a greater loss in your stock position in real dollar terms than you will in your option position. The objective of covered call writing is to produce monthly investment income and to protect your capital.
To calculate your exact current position in the trade versus when you placed it, you must:
- Get the quote for the stock.
- Get the quote for the option.
- Subtract the current option price from the current stock price.
- Compare that number to your net cost of the trade when you executed it.
The net cost of the trade is the breakeven when you enter a trade. You can use this number as your threshold to take action if the stock price decreases to this point. Some covered call investors use the breakeven to unwind a trade. If the new net number is below your stop-loss threshold – let’s say 20% – then you have the following options:
- Either: Stick with the position and hope that the share price recovers, so you can sell another option at expiration.
- Or: Reverse the trade by buying back the current option and selling the stock.
- Or: You can also buy back the option and sell another one at a lower strike price to mitigate some of the loss. However, if the new strike price you choose is below your cost, then you’re going to take a loss there, too.
- Or: Buy a protective put on the stock used in the covered call trade. The put will increase in value if the stock price falls so it will hedge losses from your stock ownership. Of course you can buy a put as protection for all covered call trades especially when you plan to continueously sell calls each month on the same stock. If you use a protective put, then select a month with a longer timeframe than the call sold against the stock.
But there’s one way to pretty much avoid this situation entirely… Sell deep-in-the-money calls against your position. While this does reduce the overall return available, the upside is that it also reduces your net cost significantly and thus provides a nice cushion against risk.