INVESTING
3 Situations Where Covered Calls Don’t Make Sense
Protect your profits by avoiding these common mistakes.
Covered calls are great, but selling them at the wrong time can be expensive.
I’ve learned that the hard way.
Fortunately, these situations are easy to identify…once you know what to look for. Here are three red flags (not an exhaustive list!) that you can heed to preserve capital and sleep better at night.
I’m not a financial professional. This is purely opinion and entertainment, not advice. Do what’s right for you, and if in doubt about what that is, then it’s important to find someone who’s legally able to tell you.
Red flag 1: Strike prices are few & wide
It’s hard to balance risk and return when the distance between strike prices is more than about 3-5% of the share price.
This is especially common on cheap stocks. For instance, one might trade at $9.98 with strikes of just $10.00 and $12.50. Your choice is:
A) Highly likely assignment at $10.00
B) Trivial premium at $12.50 (if there’s any trading volume at all!)
This isn’t relegated to “cheap” stocks, either.
Consider BTI: it currently trades around $37.00 yet its option chain skips from $35.00 to $40.00. Looking a couple months out, your call deltas are either 75 or 15, with no middle ground!
If you truly don’t mind one of those outcomes, then go for it.
But if you’re buying the stock in order to write covered calls (a “buy-write” transaction), then you may find yourself frustrated by the large steps between strikes, often waiting weeks or months before the share price gets sufficiently close to a strike price, and unable to roll your call if need be.
(I’m not big on buy-write plays in general, but if that’s your thing, then this underscores the importance of getting familiar with the option chain before opening the position.)
Red flag 2: You’d lose sleep over losing shares
If the thought of selling at any reasonable price distresses you, then just don’t sell the call.
Yes, that’s obvious, but it can be hard to stick to.
Fortunately, most of us learn that lesson quickly. One instance of sacrificing a great long-term position for a short-term fix of premium usually creates enough regret to drive home the point.
I missed out on over $1000 in capital gains on PFE by breaking this rule just once, with a single contract, in the last few months. I let my greed for premium override my long-term conviction, and paid the (opportunity) cost.
Never again.
Red flag 3: The stock price hasn’t budged in weeks
I’m not big on timing the market, especially not based on charts.
But when the stock has been unusually quiet, odds are good that a big move will follow.
Up? Down? Both in quick succession?
Beats me.
In any case, unusual quietness is seldom favorable as an options seller. Unless you’re no longer bullish on the company (that’s another matter), then consider waiting for a rapid move in order to a) collect more premium at a similar strike price or b) collect similar premium farther out of the money.
Remember, “big” is relative. The huge PFE move that I mentioned earlier is just par for the course with TSLA.
Of course, that barely scratches the surface of potential signs of trouble.
But the three above are perhaps the most common, easily identified, and readily avoidable red flags.
They’re also clearer in hindsight (what isn’t?!), so don’t be too hard on yourself when you stumble en route to experience and intuition.
