As I was worried last week how to deal with my covered call trade I opened on Realty Income – see the trade here, this trade has changed into what I wanted in the first place. See the original trade here.

As I wrote in my previous reviews of the trade I mentioned that every investor or trader must have a plan before he places a trade. I tried to describe my plan in regards to this trade.

The plan is actually either a written or mental procedure of what you would do in each situation should that situation happen. With having this plan perfectly in place for each situation you won’t panic when that happens not knowing what to do.

I had a plan for a situation that the trade would go against me and that made me calm down. I actually was able to see some benefits of this trade going against me and you know what? I actually wanted this trade to go bad, because I liked the idea of taking the loss for tax purposes and significantly improve my cost basis of this stock.

This was a tight trade and tough one. Until the very last moment I didn’t know how the trade would end up. On Friday 10 minutes before 2 pm (MST) I was sitting in front of streaming chart having my finger on the “buy” button being ready to buy back the call. The reason why I decided not to let the covered call being assigned was that its price at the end of the day was only 15c (although the option was in-the money) so it was better to buy it back than let it being assigned. But literally a few minutes before close, the stock price dropped below strike and remained there making the option worthless.

By that I collected 100% gain or $61.21 for the flat trade (1.49% gain or 25.18% annualized return). Not bad if repeated every month, right?

So what will be next? Shall I open another trade?

I am planning on opening another covered call for October or November 2013, but right now I will be in a waiting mode. The reason that I do not want to jump in another covered call trade is that I do not know what the stock may do and I am receiving different signals.

From the chart above I can see the following signals:

1. The Chaikin Money Flow index indicate money flowing out of the stock – investors are heavily selling. It is of course apparent from the price action chart – negative
2. The price of the stock just bounced off of the long term (the yellow line) trend. The yellow trend line indicates more than 5 year trend, so this is a significant bounce – negative.
3. As the price bounced it also created a new lower high confirming the downtrend with no signal for reversal – negative.
4. And here comes something what makes me unsure of the trend continuation – the trade volume spiked way above average. That may actually indicate a capitulation or end of the trend (trend reversal). It may not happen right away, but will this trend continue until the October expiration?
5. This price action is confirmed by Bollinger bands which are getting narrower. That typically means that the stock is ready for a significant price action. Unfortunately, the Bollinger Bands won’t tell you which direction that price action would be, whether up or down. And these are the two reasons why I decided to wait and take action later upon confirmation of either a trend continuation or reversal.

When I will be sure which direction the stock will go, I will either sell another put or covered call contract. Until then I am waiting for my trade.

I have a few option trades expiring tomorrow and they are all in good standing and most likely expire worthless.

I also have Realty Income covered call trade open set to either expire worthless or execute. What will happen? I do not know. I do not know whether the contract expires worthless or will be executed. If I knew I would be predicting the future. Unfortunately I do not know how to predict the future.

I only can react to what is happening and what will happen tomorrow.

When I was opening this trade last month, see details of this covered call here, I knew the trade was very tight.

I was very close to the strike price and the stock’s fall was slowing down making it a bottom or consolidation. The chance that the stock will break up above the strike price of $40 a share was quite high.

For the whole month the stock was attacking this level, but mostly stayed below. Except yesterday when the market was pushed up by tapering halt by FED. The stock shot well above the strike.

Although it is now correcting back down, it is not certain that the stock falls down below 40 dollars and the execution is very likely.

If you follow my blog, you know that I sell covered calls against stocks which I do not mind being called away. Well, Realty Income is not that stock.

Realty Income is one of my precious stocks, usually called as core portfolio. I was buying this stock for dividend income. And it looks like that tomorrow I will be forced to sell 100 shares of my Realty Income stack.

What can I do to deal with this situation?

It is a very important part of investing or trading. You have to have a plan for every possible situation to be able to repair or deal with the trade.

Based on the current price action I have the following options to do:
 

1. Roll the covered call away in time.
2. Roll the covered call away and up
3. Let the covered call be exercised

Roll the covered call away in time

This strategy is easy and it is exactly what it says. I would buy the September covered call back and sell the same strike covered call with expiration in October.

With this step I would buy the stock more time. But the strike price would stay the same – 40 dollars. Will the stock stays bellow 40 dollars in October? Maybe. But I do not know it and when looking at the chart I am not convinced about the direction. I do not see any substantial pressure neither up or down.

With this outlook I am not much confident extending this trade, although it most likely will be a credit trade and I will make more money. But the risk if too big for me.

The stock may continue up and by October it may end up at 45 dollars a share and in that situation it will be a lot worse fixing the trade. So I am not in favor of this approach.

Roll the covered call away and up

This fix would mean that I would buy the existing September 40 strike call back and sell a new 45 strike in May 2014 expiration call. I will move my strike higher and further in time. The problem with this trade is, that although I buy more time and room for the stock to go, it will be a debit trade. I will pay for this trade almost everything the original trade has made. And yet I will extend my uncertainty. So what’s the point? I do not see too many benefits yet.

Thus this trade is also unlikely for me to take to fix this trade.

Let the covered call be exercised

Surprisingly this is an option I currently favor to take. If you just read above that I do not like my stock to be called away, you may be asking why I am OK to let this trade be exercised?

Here is my point of view.

When exercising a covered call option like this one I have, you can chose which shares you deliver to the buyer on the other side of the contract. If you take a look at My Trades & Income chart you can see that I bought some of my Realty Income shares for $50.24 a share! today it looks crazy, but back then it looked like a great opportunity.

I can take those shares and sell them to the buyer for 40 dollars a share. Sure I will take a loss, but this gives me an opportunity to buy my shares back on the following Monday for a lot cheaper price!

Here is my expectation:

I will sell 100 shares which I bought for $45 – $50 a share and sell them for 40 a share tomorrow.

I will immediately buy 100 shares of Realty Income on Monday for $40.50 – $41 a share and replace my original shares.

Although this is mostly administrative procedure, it will significantly improve my cost basis of my overall holdings. I will take a loss which I apply against taxes (which is already accounted for in my account value anyway), lose very little on transaction fees, and end up with the same amount of shares for lower cost.

I wouldn’t be able to do this step if the covered call was too ITM, but being ATM will not cost me almost anything and improve my overall holdings.