How to Fix Covered Calls

Close your covered call trades in a down market.

Covered call writing is a trading strategy that involves buying a stock and simultaneously selling a call option against the stock. The strategy profits if the stock stays level or moves up slightly and the trader gets to keep the premium for the sold call. The covered call strategy has limited downside protection--the amount of the call premium--if the stock's value starts to decline. The trader using covered calls must be ready to fix or repair the trade to minimize the losses when the trade does not work as planned.

Instructions

1. Set a share price on the stock owned as a stop loss--a price to get out of the trade. A stop loss should be set with every covered call trade. If the stop loss is set at the stock purchase price less the amount received for the call option, the trade can be closed out with the loss limited to the commissions paid. The stop loss must be manually tracked.

2. Buy back the option contracts if the stock price reaches or falls through the stop loss price. The option side of the covered call must be closed out before selling the stock to avoid having an uncovered call, which most brokerage accounts do not allow.

3. Sell the stock after the options position has been closed with a purchase. Ensure the option position is closed before entering the trade to sell the stock.

Tips & Warnings

• Covered calls seem like an easy way to make money when the market is stable. The market can change directions in a hurry and the covered call trader must monitor his position for sudden changes.

• If the underlying stock is falling in value, the bid/ask spread on the option can widen, making it difficult to buy back the contracts at a decent price. It may be more important to get out of the trade than to get a good price, so consider using a market order if the market for the options has sufficient liquidity.

• Covered call writing is not an appropriate strategy for a rapidly moving market, either up or down. Avoid trying to guess the market direction. Covered calls provide limited return and the possibility of very large losses.

• Writing covered calls on volatile stocks will show attractive profit potential. These stocks also have a higher probability of a negative return trade.

References

• Options Mentoring: Covered Calls-The Downside