Using Call Options to Part Ways with Underperformers

by Tyler Craig | March 30, 2012 7:00 am

Using Call Options to Part Ways with Underperformers

life preserver 250x150 Using Call Options to Part Ways with Underperformers[1]With the advent of springtime, many investors are emerging from hibernation and taking a renewed look at their portfolios. Since this past winter has by and large been the playing ground of the bulls, most stocks in investors’ portfolios have flourished. However, there are the inevitable stubborn stocks that have refused to participate in the bullish festivities by exhibiting relative weakness to the broader market. If you wish to rid yourself of these “annoyances” in your portfolio, consider the following strategy that may help make a little money back before you part ways.

Suppose you purchased 100 shares of Potash Corp. of Saskatchewan, Inc. (NYSE:POT[2]) in November of last year at $48. Though the S&P 500 Index has risen considerably since then, POT has meandered lower and now sits at $45.40.

Rather than simply selling the shares and incurring the$260 loss (which of course would also eliminate the risk of losing additional capital), you might consider selling an in-the-money call option. This offers you a modicum of protection while giving the potential to recoup some, if not all, of your loss.

In the case of POT, let’s say you sold the May 45 call for $2.45. By selling the call, you obligate yourself to sell your stock at $45. In exchange for assuming this obligation, you’re compensated by receiving the credit of $245.

When selling in-the-money covered calls, your profit potential is limited to the amount of extrinsic value in the call option. Since the May 45 call is in the money by 40 cents and is worth $2.45, it has $2.05 of extrinsic value.

That $205 ($2.05 x 100) represents what you can make by May expiration if POT remains above $45. Though the $205 won’t allow you to recoup your entire $260 loss, it does offset the majority of it.

The principle drawback with this strategy is that you will rack up additional losses if the stock continues to fall. The protection afforded by the short call is not comprehensive. In the event you think the stock is simply going to rip lower, don’t sell the covered call. Just unload the stock and move on.

In the end, selling in-the-money covered calls can be an alluring method for ousting troubled stocks from your portfolio.

For additional strategies that can help recover some portfolio losses, check out Spring Clean Your Portfolio With Options[3].

At the time of this writing, Tyler Craig had no positions on POT.

Endnotes:
  1. [Image]: http://investorplace.com/wp-content/uploads/2011/05/life-preserver_250x150.jpg
  2. POT: http://studio-5.financialcontent.com/investplace/quote?Symbol=POT
  3. Spring Clean Your Portfolio With Options: http://investorplace.com/2012/03/spring-clean-your-portfolio-with-options/

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