Recently I opened a covered call position in DMD using a total return approach, which means that I am expecting and want the stock being called away.

I used a low priced stock, since that would provide a higher return than higher priced stock when using small account (or small amount of money available). I will always use stocks priced between $7 to $15 (at least during time of limited money to invest).

My next step in covered calls or plan is to build a ladder (opening a buy-write positions spread into every month thus having expiration in every month).

I started my plan with DMD, which met my criteria and looked bullish. A covered call strategy is a bullish strategy, when you expect the stock actually rise above strike and you get assigned. Once you get assigned, you take the proceeds and repeat the process. You can do the same with the holdings in your account and be a partial return covered calls writer meaning you do NOT want your stock to be called away.

That however, brings some issues. You have to pick your strike well above the current underlying price to provide your stock some cushion for growth and that will lower the premium received so down that it may not be feasible to write calls unless you can write several contracts instead of only one as in my case. I currently do not have enough money in my account and enough shares to write more than one contract.

I also do not want to deal with potential assignment if the stock progresses too far and I will have to roll the call contract up and far away which may be done at a loss or break even. Other reason would be a potential loss of dividend if you happen to get assigned.

So I was thinking a lot if it makes sense for me to write calls against my core holdings or not and I found out that I wanted a peace of mind when dealing with covered calls and decided to use a total-return approach and buying stocks dedicated for this strategy and which I do not mind if they get called away.

I was recently studying a lot how that works and to demystify all the blurs and myths about covered calls I had. I must say I had a totally wrong point of view at covered calls and how they work.

So how my DMD position works so far?

I bought 100 shares for $9.5 per share for a total of $950. I sold one contract of February $10 strike call at the same time for $0.60 per contract. I received $60 premium. That lowers my base price for the stock to $8.90 a share. That means, that the stock can drop in price to $8.90 and I still will be at least break even. If the stock stays at the current price level (below $10 a share) and above $8.90 a share until February 16th, the current option contract expires worthless, I keep the premium and the stock. I can immediately sell another $10 call option for March, which would lower my base of the stock even further down and allows for the stock being called away in March. Or I can repeat this process indefinitely or as long as the stock is called away. But that can be done if the stock price is neutral or slowly drifting down. Of course the best would be if the stock grows up and reaches its strike or exceeds it and is called away.

So the plan is nice and great so far. But we are facing the fiscal cliff problem. Our politicians seem to have no balls to deal with it. It looks like Obama’s strategy is to let the Bush’s cuts expire, so he can blame Republicans for it and when that happens the country will head to another recession and at that time he would come out with his own cuts, which can be no longer called “Bush’s tax cuts” but “Obama tax cuts” (so that loser can have his name at least on something, some bill) and he could be called the “savior” (I do not want to use capital “S” because that communist doesn’t deserve anything close to it, and there is only one Savior in the world).

So what will most likely happen to stocks when this scenario materializes?

The stocks will tank.

This will be potentially good for the long term investors such as us – the dividend investors, since we will be buying many of the stocks for great low price (and I am actually looking forward to it).

But there will be some positions which will get hurt. One of them is my covered call, which is a bullish strategy and the stock may tank faster and way below my break even price. If that happens, you cannot roll out and away easily, selling more calls won’t effectively offset the loss, and you will stay locked in a losing position. Do you want to take the loss and move on or is there any back-up plan to repair such position?

If that happens and DMD tanks at or below $8.9 a share I will close my existing $10 strike call (buy back) for 0.14 a contract. That will provide me an option income of 0.46 or $46 ($60 of original income – $14 buy back). But I will be losing $60 on my stock position. The net gain would be negative $14.

I would have two options – take a loss and move on, or try to repair this position. If DMD falls at $8.9 a share, I can sell ITM (in-the-money) $7.5 May 2013 calls, receive 1.66 premium, and let the stock be assigned. So the numbers will be as follow:

$950 stock – $750 assignment = $200 loss
200 loss – $46 original premium = $154 loss
$154 loss + $14 original call buy back = $168 loss
$168 loss – $166 new premium = $2 loss
(and plus commissions)

With one contract in my account, it probably will not make much sense going thru this repair but in case of having 10 contracts, the difference can be either 140 dollars loss vs. 20 dollars loss when performing the repair. Another option would be to buy back the original call contract and sell one more short term (ideally same month) OTM call contract and when that one expires, then sell ITM contract as described above to eliminate the loss completely and make it a gain. The numbers would look like the following:

$950 stock – $750 assignment = $200 loss
200 loss – $46 original premium = $154 loss
$154 loss – $55 new OTM 10 call = 99 loss
$99 loss + $14 original call buy back = $113 loss
$113 loss – $166 new ITM 7.5 premium = $53 gain
(and plus commissions)

Another thing to remember is that I own a February contract and if the cliff happens in January, I still will have enough time for the stock to recover or enough time to repair the trade such as rolling the call option down and lower the stock base cost and then apply the ITM call repair. There will be a plenty of time to make the decision. One thing is for sure however. If this scenario happens I want to get rid of this trade as quickly as possible. If the stock stays above my current base cost, I am fine keeping the stock and continue selling more calls against it.

I am sharing this strategy as a back-up plan in case the stock drops too low and too fast. If nothing like that happens, fine I’ll be happy taking my 9.15% gain on original trade or continue selling more calls. If the stock falls down or below my break even, I will try to use above described approach to repair it and end the trade with zero loss (commissions included) or a small profit as quickly as possible and move on. Let’s see what January 2013 brings.