Call selling during a downturn

by Jay Pestrichelli on November 16th, 2012

As a follow up to yesterday’s post Keep playing Defense that addressed how to manage your protective puts, here’s some info to consider on the upside you sold away. I sold away upside you say? If you wrote calls then you smartly got paid for upside that never happened. In other words, you sold it away. As a disciplined hedger, you are probably used to selling calls to help offset the cost of your protection whether it be in a spread or a collar.

One thing to consider is to sell calls multiple times in a single month. When the short calls decrease in value quickly and the income generation is accelerated, it makes sense to consider doing it a second time in the month.
 
Typically, we use the 80%-85% decline in call value as the mark where we consider taking action. Of course time has to be a consideration. So if there are only a few days left till expiration, its probably best to let that last 20% depreciate. However, if there is plenty of time left, there’s little left to wait for, so take the gain early.

So if you've taken your short call profits early, as we have with some of our clients this week, the question arises what to do next. The choices are to sell calls again immediately at a lower strike while the depressed stock is down or to wait to sell on a rebound upwards. This turns into a little bit of a timing game, and one we don’t’ typically subscribe to. But since you've made most of the monthly income already, you have just afforded yourself a little time to wait.

The risk of selling calls at a now lower strike is that you may get assigned if there is a sharp snap back  Typically this is not the case as the markets move up slower than they move down. But that is a generalization that we don’t bank on…we’re just aware of it. So use the normal criteria you use to determine you limits and you’ll probably find the trades are a little friendlier as the volatility component of the option price has probably increased. In other words, you should get more for the same amount the call is out-of-the-money as you had before.

If you’re inclined to wait for a rebound you may find yourself waiting a long time. So set your time limit and the desired strikes you feel comfortable using before just deciding to wing it. If you do get that bounce you waited for, you’ll feel like a genius. But don’t let this good judgment falsely inflate your confidence as this becomes the riskiest time to place that call trade. If in fact the symbol has turned upwards, selling at the beginning of the rally will increase the likelihood of assignment. This means you have to be comfortable with the level of the strike, as you always do. So a safer way to do it is to keep the same expiration as the first call you sold. Don’t go out another month if you don’t have to. If that is the case, you can afford to wait a little more to match your timing with your upside limits.

On the whole, we've found that a regular and disciplined approach to selling calls is the best way. Pick a method that you've been successful with and stick with it. Just because you’re in a looming bear market doesn't mean you have to throw out all the good learning you've had on the way up. 


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