Monday, May 20, 2013

covered call playbook: rescuing a losing stock trade


here's a real trade in distress: long slw stock at 23.70 (you know who you are) and sold the jun 23 calls for .62/share (ok this part is fiction, but was proposed.) now slw is trading at 23.18. the trade looks like this in the analyze tab:


slw covered call simulation

the shares of slw were acquired previously then the stock went down. a call was sold against the shares to lower the cost basis and rescue a losing trade. then slw went up above the 23 strike and it now appears that the best we can do is scratch this trade.

appearances can be deceiving.

here's the play:
  • wait til there about 10 days left in the expiration period. at the 10 day mark there is about 40 days to go in the july expiration or 4 times as much time. at that time it is likely that the july option will price for about twice the june option. this is due to the well-known property that option time-value decays directly proportional to the square-root of remaining time and since there is 4 times as much time to go in july than in june, a double is likely because the square-root of 4 is 2. 
  • compare the extrinsic value in the june 23 calls to the roll credit. set up, but don't execute a trade to buy back the june 23 calls and sell the july 23 calls.
  • if the july roll credit is at least twice the extrinsic value of the june call then execute the trade, otherwise re-evaluate the next day. the idea is that if there is way more money to be made in the july expiry it doesn't make sense to hang on to june.
  • the roll credit further reduces the cost-basis. the closer slw is to 23 at roll-time, the greater the credit will be.
  • lather, rinse and repeat next month.


so what if slw is trading up around 30 or so when it is time to roll, won't i miss out on $7 of profit?

not necessarily, here's the play:
  • roll the call horizontally to the next expiration (as above.) if the roll credit does not produce adequate gain then close the trade (or take automatic assignment at expiration - the $15 assignment charge may be a savings over closing transaction costs.)  stay uninvested in this equity and wait for a dip to short puts.
6/3/13 revision note: previously i suggested spending money to roll to a higher strike. upon, some further reflection, i think this is not money well spent because implied volatility generally contracts as prices rise. an exception could occur for short-squeezes, where panicky shorts may cause price and iv to lift together.

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