A\u00a0 reader asked us for help in the following situation:<\/p>\n
“I have a question and wonder if you will help.\u00a0 I would appreciate very much any advice that you can offer.<\/em><\/p>\n I have 100 shares of\u00a0 GMCR stock and\u00a0 I have written a covered\u00a0 call– June\u00a0 ‘ 11\/ strike 43– against it . \u00a0The stock gapped up from 41 to 57\u00a0 recently. \u00a0How can\u00a0 I repair my situation\u00a0 in that I am\u00a0 losing $1100 on the covered\u00a0 call\u00a0 yet\u00a0 I can’t sell my\u00a0 GMCR stock because of the covered\u00a0 call against it?”<\/em><\/p>\n Lee\u00a0 (writing in from China) One of the\u00a0 most popular\u00a0 directional options strategies is the “covered call”\u00a0\u00a0 which is also known as the\u00a0 “covered write”.\u00a0\u00a0 The covered call strategy is basically a “campaign” that is predicated on a trader’s bullish opinion on a stock,\u00a0 ETF or index.\u00a0 The strategy is often employed by holders of long term equities who are looking to milk some extra income out of certain stocks in their portfolio.\u00a0 Other times,\u00a0 traders will simply select a single\u00a0 equity about which they have formed a bullish bias and undertake a covered call campaign around that stock.<\/p>\n Like every trade, there is an upside and a downside to the covered call.\u00a0 If the trader is\u00a0 “too” wrong and the stock\u00a0 sells off substantially, the trade will be a loser–at least in the short term–because the loss on the shares will outstrip the gain on the short call.\u00a0 If the trader is “too” right, the covered call will limit the trader’s\u00a0 upside to the appreciation that the stock will enjoy up to the strike price of the short call.\u00a0 The trade will be a winner, but not as big a winner as it would have been to have simply been long the stock or long a deep in the money call (a “synethetic” long\u00a0 stock position).\u00a0 However, if the trader is a little wrong or a little right, the covered call strategy will easily outperform a simple long position in the stock and can turn losing share holdings\u00a0 into winning trades or flat boring equity positions\u00a0 into outstanding\u00a0 winning trades.<\/p>\n In this case, Lee actually commenced his campaign cleverly by selling a naked October ’10 $30 \u00a0 put on GMCR, picking up $138 of option premium which he pocketed when GMCR was trading at $34 last September.\u00a0 GMCR\u00a0 then\u00a0 fell below $30 and he was assigned 100 shares of GMCR \u00a0\u00a0 upon the expiration of his put.\u00a0 So Lee was off to a good start,\u00a0 picking\u00a0 up $138 of income on a stock that he was willing to own at $30 anyway.<\/p>\n Over the next three months, Lee cleverly milked his $3000 investment in GMCR stock selling slightly out-of-the money\u00a0 calls and puts around his core GMCR long stock position then\u00a0 buying them back as the stock fluctuated in price, buying back \u00a0 the calls and puts\u00a0 when\u00a0 they shrunk in value to a fraction of their original sale price.<\/p>\n The day before GMCR’s\u00a0 monster one day $18 point rally last week, here was Lee’s position: \u00a0 in addition to holding\u00a0 the GMCR\u00a0 shares as they appreciated 45% above his original purchase price (the $30 per share that he shelled out when he was assigned the shares last October) \u00a0 Lee milked another 10%\u00a0 from his shares by skillfully selling calls and puts around his core long position.<\/p>\n The day after the monster up move, Lee’s “campaign” was up 58% in six months–a VERY successful covered call campaign.<\/p>\n It is true that if Lee had\u00a0 simply purchased the GMCR shares at $30, his appreciation at the end of last week would have been closer to 100%.\u00a0 However, had the GMCR shares appreciated more gradually, the covered call approach\u00a0 would have\u00a0 almost certainly continued to outperform a buy and hold shares strategy handily. Again, if the trader is “too” right, the covered call strategy will be successful, but may or may not be as successful as buying and holding the shares.<\/p>\n So first off, I’d argue that\u00a0 there is nothing\u00a0 to”repair”. This trade is a tremendous success.\u00a0 Lee just has to make a decision as to where he wants to go from here with this campaign. If Lee has achieved his planned objective on the trade or believes the stock is due for a correction, he can simply cover the call and sell the shares simultaneously locking in his excellent gain.<\/p>\n
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