covered call loss example - is this correct? (beginner)

S

stockmarketbeginner

Hello,

I am reading about about how you can "buy back" a covered call you sold. You would do this if the stock is losing value and you want to get out of the stock.

However, no concrete fully-worked example is provided in the texts I have read (books, online). So I created my own example. I was hoping someone could evaluate if my example is realistic in terms of the money flows. For simplicity, I am eliminating transaction costs:

The stock is selling at $84.
You buy 100 shares.
The strike price is $85.
The premium per share is $0.46.
You write the covered call and get $46 premium.

Then the stock price declines to $83 and you want out of the stock.
Before expiration, you "buy back" the $85 strike price covered call option you sold, but at $0.10 per share (the current stock price is now further away from the strike price and time has passed, so it is worth less than $0.46).
So you pay $10 premium to buy the option back.

You then immediately sell the stock on the open market for $83, since you are no longer obligated to hold the stock.

So you end up with these financials:
-$100 loss on stock + $46 first premium - $10 second premium = -$64

This means you took at $64 loss, which really isn't that bad.

Did I get the basic mechanics of this correct?

Thank you.
 
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Correct! The profit from selling, the call, insulates you, a little bit, from the fall in stock. It's not sexy as you leave, the huge upside, on the table but it's a nice way to trade around, a position. Most likely, you'd just let that $85 call expire worthless, and collect full premium. I have a FCX position, and while it hasn't done much this year even though copper is at 3yr. highs, it is volatile enough to provide short-term gains. It's been between $12-$15, all year, so sell covered calls at high side and buy back on low side, not worrying about being "down" on your share position.
 
Your numbers are correct. Unless you are legging in or out in an attempt to get a better fill, utilize a Buy/Write order to simultaneously execute both legs of the transaction.

For your opening transaction, the B/W would be to buy at -$83.54 and to close the position, it would be to sell at +$82.90

In either case, you don't care what the individual legs are filled at, only that you get the price indicated. So for the closing transaction of +$82.90 it could be (+$83.00 -0.10) or (+$83.01 -0.11) , etc. The advantage to this is that in the few seconds between closing both legs one at a time, price can change and you get a better or worse fill on the second leg.
 
spindr0 said:
Your numbers are correct. Unless you are legging in or out in an attempt to get a better fill, utilize a Buy/Write order to simultaneously execute both legs of the transaction.

For your opening transaction, the B/W would be to buy at -$83.54 and to close the position, it would be to sell at +$82.90

In either case, you don't care what the individual legs are filled at, only that you get the price indicated. So for the closing transaction of +$82.90 it could be (+$83.00 -0.10) or (+$83.01 -0.11) , etc. The advantage to this is that in the few seconds between closing both legs one at a time, price can change and you get a better or worse fill on the second leg.
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Or instead of buying shares and selling a call, just short a put at the strike price of the call ($85 in this example) to reduce your commissions. Puts usually trade at somewhat of a premium to calls anyway due to borrowing costs. Even if there is a dividend coming up, that should be priced into the options. Only reason not to do that would be if the spreads on the ITM put are wider than the spread on the OTM / ATM call.

In your example, if the stock drops to $83 and I'm long the stock at a cost-basis of $84, I'll be looking to sell another call at $84 and possibly further out until expiration. Depends on how much time I have until expiration and I'm assuming that the underlying is not that volatile.
 
Given the OP is a beginner, I suggested utilizing the B/W order instead of legging out. If the OP has approval for naked options (not cash secured) then the synthetic short put is usually a better since it involves fewer spreads and commissions.

If we're going to advance past beginner level then I'd suggest spreads instead of short puts/BWs in order to shift the R/R away from the unbalanced payoff. As for puts trading at a premium to calls, AFAIK, that's if the borrow cost exceeds the carry cost (assuming no dividend).
 
spindr0 said:
Given the OP is a beginner, I suggested utilizing the B/W order instead of legging out. If the OP has approval for naked options (not cash secured) then the synthetic short put is usually a better since it involves fewer spreads and commissions.

If we're going to advance past beginner level then I'd suggest spreads instead of short puts/BWs in order to shift the R/R away from the unbalanced payoff. As for puts trading at a premium to calls, AFAIK, that's if the borrow cost exceeds the carry cost (assuming no dividend).
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Put spreads do have reduced risk as well as reduced profit (when comparing 1:1) relative to the naked put, but they also have a lower probability of profit. Depends on the instrument, conviction, and account size. When I'm less certain of being right, I move towards the put spread or buy options. For example, on something like AMZN or AAPL, I'll sell naked puts. On something like an airline or PCAR, I'll buy calls or sell put spread.
 
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