A strategy idea for options trading investors.
Overview
The recent market sell off has reminded investors of the importance of risk management. A trader’s survival hinges on the ability to minimize losses so it is imperative to have a game plan for dealing with adverse moves in stock prices. Investors reticent to simply sell their stock positions may consider using options to protection their long side. Buying puts, selling calls, or entering a collar trade are all appropriate strategies. Let’s look at a covered calls trade.
The conventional approach for most covered call enthusiasts is selling out-of-the-money call options to produce passive income. Another benefit of selling calls is that the premium received also represents downside protection. If you sell a covered call for $1, then you have acquired protection against a $1 drop in the stock price. The amount of downside protection can be increased by selling lower strike calls with more premium. This is the primary incentive for traders to consider selling in-the-money call options against stocks they own.
Covered Call Trade: Baidu.com
Suppose an investor purchased 100 shares of Baidu.com (NASDAQ: BIDU) around $130. With a current price near $123.00 his unrealized loss sits at $700. To acquire downside protection as well as put him in a position to recoup the loss over time, the investor may consider selling an in-the-money covered call. Keep in mind the potential profit when selling an in-the-money covered call is limited to the amount of extrinsic value embedded in the option premium. Thus, it’s usually best to consider calls residing within the first two or three strikes in-the-money.
Let’s say this investor sold the BIDU Sep 115 Call for 15.30. Such a defensive action accomplishes two things. First, the stock owner receives a decent amount of premium to partially offset a continued decline in the stock price. Second, the covered call offers the ability to not only recoup the $700 loss, but also potentially gain $30 in the trade. This swing in the position’s PnL is due to the amount of extrinsic value currently priced in the call option. At $15.30 it contains $8 of intrinsic value ($123-115) and $7.30 of extrinsic value (15.30 – 8).
Covered calls can be very effective risk-reducing vehicles. Don’t discount their protective nature.
At the time of this writing Tyler Craig had no positions in BIDU.
Follow Tyler Craig on Twitter@TylersTrading.
