34 lines
2.3 KiB
Plaintext
34 lines
2.3 KiB
Plaintext
Chapter 2: Covered Call Writing 71
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1. protective action to take if the stock drops,
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2. aggressive action to take when the stock rises, or
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3. action to avoid assignment if the time premium disappears from an in-the-money
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call.
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There may be times when one decides to close the entire position before expiration
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or to let the stock be called away. These cases are discussed as well.
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PROTECTIVE ACTION IF THE UNDERLYING STOCK DECLINES IN PRICE
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The covered writer who does not take protective action in the face of a relatively sub
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stantial drop in price by the underlying stock may be risking the possibility of large
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losses. Since covered writing is a strategy with limited profit potential, one should
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also take care to limit losses. Otherwise, one losing position can negate several win
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ning positions. The simplest form of follow-up action in a decline is to merely close
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out the position. This might be done if the stock declines by a certain percentage, or
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if the stock falls below a technical support level. Unfortunately, this method of defen
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sive action may prove to be an inferior one. The investor will often do better to con
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tinue to sell more time value in the form of additional option premiums.
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Follow-up action is generally taken by buying back the call that was originally
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written and then writing another call, with a different striking price and/or expiration
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date, in its place. Any adjustment of this sort is referred to as a rolling action. When
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the underlying stock drops in price, one generally buys back the original call - pre
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sumably at a profit since the underlying stock has declined - and then sells a call with
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a lower striking price. This is known as rolling down, since the new option has a lower
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striking price.
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Example: The covered writing position described as "buy XYZ at 51, sell the XYZ
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January 50 call at 6" would have a maximum profit potential at expiration of 5 points.
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Downside protection is 6 points down to a stock price of 45 at expiration. These fig
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ures do not include commissions, but for the purposes of an elementary example, the
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commissions will be ignored.
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If the stock begins to decline in price, taking perhaps two months to fall to 45,
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the following option prices might exist:
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XYZ common, 45;
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XYZ January 50 call, l; and
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XYZ January 45 call, 4. |