In response to requests from readers for more information on managing covered calls, today we have equities and options expert, Rich Melbourne, who uses the covered call (or buy-write) strategy extensively, to share some of his ideas on how he manages covered calls for himself and his clients. Today he will be discussing what to do if the share price goes up after you sell your call options and your calls are now in-the-money (ITM)…

Good Morning Readers,

As expiry approaches, I am often asked by investors who are new to the buy-write strategy: “So we are in the money, now what..?”  The answer is simple enough: either roll up or allow yourself to be exercised and move onto the next position. What many investors forget is that the whole aim of the strategy (in its simplest form) is to be exercised – after all, this is when you achieve the maximum profit of the strategy.

Sounds simple right..? Well, there have been circumstances when I have inherited clients who have purchased stock well above the current share price and written calls all the way down as the share price falls. This is the first mistake and comes back to the most basic of investing rules: never fall in love with a stock. Stop losses people! Be it technical or a fundamental change; if a company isn’t what it was when you bought it then you need to cut your losses and move on. In this game you will experience losses, but the goal is to get more wins on the board than those losses. It can be easy to fall into the trap of the ‘everlasting roll’ where you feel as though your only option is to roll as you don’t want to crystallise a capital loss…

So what do you do then? You bought XYZ at $66 back in the day, and it’s now trading at $35 with a $32 call written on it – but wait, there’s more! Couple this with the fact the stock is paying a dividend next month (meaning the premium will be less than normal as the dividend is taken in to account) and your options for rolling are very limited… First thing you must do is a reconciliation (see Tip below for an easy way to do this) of your position. How much income have you received along the way and what is your overall dividend position? It just may be that your situation isn’t that bad… Secondly you need to see if you can roll the position UP! Time and time again I have seen so called investment professionals roll a position down to preserve the stock and receive a credit. Come on guys, this is crazy. Why go backwards when you are already underwater..? If necessary, pay that extra couple of cents to see a higher exercise price. It may cost you 5c to roll up 50c, but at the end of the day you will be 45c better off at the end of the month (if you are exercised).

If you are one of the lucky ones who are at a break-even level or, heavens forbid: in profit after you have reconciled the income received, you have the unique opportunity to end your pain and move into a new trade which is fundamentally sound and technically attractive. The big question to ask yourself is this: “Would I buy this stock at these levels given the current position of the company and economic circumstances?” If the answer is yes, then by all means roll out another month and enjoy the premium you receive, but if your answer is no, then you need to let the position go and move into something with growth prospects on the horizon. It’s never fun taking a loss, but if you don’t take action then your investments will not move forward.

All in all: keep your focus sharp and don’t forget why you started trading – to make money, not to nurse a sick position in the vain hope of recovery. My personal mantra is: Knowledge is King. Always stick with quality and be pre-emptive rather than reactionary. When you create a quality and disciplined trading strategy; stick to the rules and the stocks you decide to use for the buy-write should turn into little gems.

Also – this is in no way, shape or form financial advice; this is simply an opinion piece discussing theoretical strategies that may, or may not, work for you. Everyone’s appetite for risk is different and we all have differing financial goals. Always speak with an investment professional BEFORE making any investment decisions regarding any products I have mentioned in the article above.

The information provided in this post is general information only. Unless otherwise stated the information is not designed for the purpose of providing personal, financial or investment advice. Any examples are presented for illustration purposes and past performance is not a reliable indicator of future performance. The information provided does not take into account your particular investment objectives, financial situation or investment needs.

Without limiting the generality of the above paragraph no person, persons or organisation should invest monies or take action on the reliance of the material contained on this post, but instead should satisfy themselves independently ( whether by expert advice or otherwise) of the appropriateness of any such action. Unless otherwise stated the information presented is not a recommendation to invest in any investments, securities or financial products.

Whilst all care has been taken in compiling information in this post, and is provided in good faith, it is not to be relied upon as a substitute for professional advice. The views expressed are commentary only and the writer accepts no responsibility for the accuracy, completeness or timeliness of the information.

Tip: If you use the LRI income tracker tool (see Portfolio Tracker on the Resources page) you can very easily see all the income you have received over time for a particular stock by turning on the data filter in Excel and filtering by the stock code… Christina.

Richard Melbourne is an Equities & Options Advisor with Excela Equities in Brisbane. He specialises in Equity and Options trading in the Australian stock market with a primary focus on providing full service investment advice for Self Managed Superannuation Funds (SMSF).

His experience with internationally respected financial institutions forms a solid, broad foundation in the finance industry. Richard holds the relevant qualifications to advise on Options, Margin Lending, CFD’s and Equity products in addition to his Bachelor of Business, majoring in both Finance and Management. Having studied markets in both Australia and the UK, he draws upon vast knowledge in domestic and international business contexts.

He is also the Author of: ‘The Rich Report: Daily Conviction’; an easy to read daily stock market report filled with economic commentary and investment recommendations. The aim of ‘The Rich Report: Daily Conviction’ is simple; to create an informative and enjoyable atmosphere around topics that many find confusing and dry. Visit www.richreport.com.au for this free and entertaining daily report.

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