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Selling Covered Calls below your stock cost basis. What to do?

The covered calls strategy is considered the safest strategy good for beginners and almost all brokers will allow you to trade this strategy in their basic options trading tier level. Yet, that doesn’t mean that this strategy is riskless and has no potential to give you a hard time trading it. It can become a nightmare and guarantee losses if you do not know what to do when this situation happens.

I trade covered calls in my accounts and I spent a lot of time thinking about how I could protect those trades when they get into trouble. And there are several strategies you may deploy to save your trade and make it a winner. The hardest part is when to pick the right one.

A typical strategy of selling covered calls is that an investor already owns 100 shares of a stock and she decides to start selling covered calls to generate additional income. I love doing it and it is my goal in my portfolio. I accumulate shares of a stock of my interest until I reach 100 shares. Once I reach 100 shares, I start selling covered calls and collect premiums on top of my dividend income. This is called portfolio overwriting.

The second most common covered call strategy is a buy-write strategy. An investor buys 100 shares of a stock and immediately sells covered calls. It is all done in one trade. Usually, this investor is not interested in holding the stock for a long period of time in his portfolio. He hopes, that he would sell his position when the call expires in the money and his shares are called away. Some investors use this strategy to create a triple income strategy. They position their trade so on top of the covered call premium they also capture a dividend. Then, their stock is called away.

No matter what you do, there is a risk involved. The risk, however, is not on the option. The option strategy is still a very safe one. The risk is with the stock.

What can happen is that an investor buys a stock, for example, for $40 dollars a share and sells a covered call with a $45 strike price. All looks great, until the stock tanks to $20 a share. The $45 strike covered call will expire worthless but the investor can no longer sell a new $45 strike because at this strike there is no premium anymore. She can sell a $25 strike covered call, but the problem is that she bought the stock at $40 and if the stock recovers and her new $25 covered call is assigned, her shares will be called away at $25 a share. This will cause a $15 a share loss (or $1500 in total dollar amount). So, what can you do to prevent this?

In this article, I will try to describe all strategies I apply myself when this happens. As I mentioned before, the hardest part is to choose the right one at the right moment.

I will list all the ideas in no particular order below and try to explain what each trade can do to your position but also what risks such adjustment can carry. Let’s begin.


 · Do nothing!


Sometimes, the best action to do is no action whatsoever. Usually, when you wake up one day, open your computer, log in to your brokerage account and find out that your stock position gapped down significantly, the best approach may be to just sit and wait. Let your original covered call expire and wait. I sometimes do this to assess my next move and see what a stock may or may not do next. Jumping the gun may not be the best approach. In today’s market, we saw fast selloffs and fast recoveries. In 2020 the March selloff was the shortest in the entire market history. The only second-fastest sell-off happened in 1987. The recovery also took a very short time. Many of my stocks in my portfolio, which were impacted by this selloff and I got assigned, already recovered and today trade higher than before the Covid selling. This may not be always the case, but in this situation waiting and sitting on my hands paid off.


 · Sell cash-secured puts instead of the calls


When your stock drops deep below your cost basis, it is sometimes better to sell a cash-secured put rather than trying to sell another covered call below your cost basis. This idea is OK if you have enough cash to cover this trade because you will be taking another obligation of buying 100 shares if the stock keeps falling. But in this case, I always managed to roll the puts down and away. At some point, the stock started recovering, and after it got back to the new cost basis, I switched to selling covered calls again. When collecting premiums, keep track of the received premiums and your actual adjusted cost basis.


 · Roll the covered call deep in the money


This strategy is good when you happen to catch the knife and start seeing your stock falling off the cliff. Let’s say, you were bullish on your stock, you bought 100 shares at $40 a share and sold a covered call at $45 strike price. Soon after, the situation in the market changes, or the company fundamentals are no longer bullish and you become bearish. The stock starts selling off and the selling is rather harsh. In this case, immediately roll your $45 strike price call deep in the money. For example, the stock starts falling from $40 a share to $35 a share, you buy back your 45 strike call and sell new deep in the money $20 strike call. If there is still enough time in the original contract, you can keep the same expiration date, if the contract has 10 days or less to expiration, roll it also away in time.

What does this do to your position?

By rolling deep in the money, you collect a premium but also an intrinsic value of the option. And that intrinsic value provides you with further downside protection. In our example, if the stock is at $35 a share and you roll to a $20 strike, you will collect, for example, a $15.95 premium. The 0.95 is the new extrinsic value, the premium you can keep, the $15.00 is an intrinsic value providing your stock a cushion that it can fall all the way down to $20 a share and you will not lose that money. Your stock will be losing $2,000 but you have received $1,500 + premiums. You effectively mitigated a large loss. With this strategy, however, be prepared that your stock will be called away. This is the last adjustment you could do. Once you do it, you won’t be able to repair it as rolling deep in the money options is not possible. At least, not for credit.


 · Swap the cost basis


This idea is a bit complex in the way how you look at a trade. Many times I look at a trade as a part of a more complex strategy, so selling and buying in and out of a position is not an isolated trade to me but a series of steps of one big trade.

What I do in this case is that I start selling covered calls below the stock cost basis and if the stock starts recovering I try to roll the calls higher and away in time. I do it for credit only. But when it is no longer possible to roll that call, I let it assign, and immediately sell new in the money put. For example, I got a stock assigned to me at $40 a share. I kept selling covered calls all the way down to $15 a share (my lowest premium was $17.50 at some point). I could roll the covered call up and down from 17.50 to 25 and back down to 20 as the stock kept bouncing around. At some point, I got stuck at 20 strike price and the stock rallied to 24 a share. I was not able to roll my 20 strike price call, so I decided to let is assign. Immediately, I sold 25 strike in the money put and let that put assign. My new cost basis dropped from $40 a share to $28 a share (with all the collected premiums, dividends, and the swap). Now I could start selling $30 strike price calls. Instead of selling cash-secured puts, you can buy the stock back immediately after it is called away to re-establish the position.

Note that this idea may not always be feasible to do. Usually, you do not want to do this strategy when the difference (spread) between the call assignment and in the money put is too large. For example, you get assigned at $20 a share but you would have to be selling puts (or buying shares back) at $38 a share. That gap is too large and the loss would be too big to be offset by this swap. So, before you do it, review the math first. Another implication of why this idea may not be always feasible is tax implications. This swap will most likely be considered a wash sale and you will not be able to use the loss for a tax deduction.


 · Sell covered strangles


If it happens to you and you sell a covered call that is already below your cost basis and on top of that also deep in the money because in the meantime the stock recovered sharply and left your calls way behind, strangles are the best strategy to get out of the hole. To create a strangle, you sell an OTM put adding it to your existing covered call. You then use a premium from the put to roll the call higher. This strategy can help you with rolling deep in the money calls which would be a lost trade otherwise. For example, you have a stock trading at $30 a share, your original cost basis was $40 a share and your covered call is at $25 a share (in the money) and unable to roll it higher. You sell a new cash-secured put with a $25 strike (out of the money) and collect a 0.45 premium. That premium will allow you to roll your $25 covered call up to the $26 strike price. As the expiration nears, you roll both legs (put and call) away in time and higher, for example, you can close a December 2020 position and open a new January position while rolling puts from 25 strike to 28 strike and call from 26 strike to 30 strike. You keep doing this as long as your calls get out of the money. I had a position against SIG stock which dropped from $25 a share all the way down to $10 a share. I converted my covered call to a strangle and kept rolling higher. I was able to keep my put strike at the same strike ($13 a share) all the time while rolling my calls higher and still collect nice premiums. Again, if you decide to deploy this strategy, make sure you have enough cash in your account because adding puts means that you are accepting another obligation to buy 100 shares of the stock if the puts get in the money. However, strangles are extremely easy to roll up or down as needed, and should the stock drop down again you can roll the entire strangle down too, this time, you will collect a premium on your covered call which will help you offset the put cost. Just make sure, the entire trade is always a credit trade.


 · Always protect your trade against early assignment


When it happens and you end up having your calls deep in the money (or puts if selling strangles), you want to protect yourself against early assignments. It is not a 100% bulletproof strategy but it works most of the time. I always roll the trade 90 days to expiration and keep adjusting every time it gets to 45 – 60 days to expiration. To illustrate it better: for example, I have 10 days to expiration (DTE) covered call, the stock recovers fast and the call gets in the money. I roll it from 10 DTE to 90 DTE and higher strike. When the trade gets down to 45 – 60 DTE, I roll it again to 90 DTE and so on. This means the expiration is so far away that it is highly unlikely that anyone would assign this early. It still may happen, but the chance of it happening is low.


 · Hedge your call with new stock position


If the stock is recovering and you can’t roll your covered call higher (for example, you have a stock that doesn’t offer too many strikes and/or premiums) then you can hedge the call by buying another 100 shares. For example, you had 100 shares of a stock with a $40 cost basis, you ended up with a $20 strike price covered call and the stock is trading for $28 a share. There are no more strikes or premiums available to allow you to roll the call strike higher and away in time. Buy 100 shares of the stock at $28 a share and let those assign.


 · Just close it


If none of the ideas above are appealing to you and all if it seems like too much work and too much hassle, then the best approach would be just to close the covered call position by buying it back. You can set a stop loss (most brokers allow you to set a stop loss on a single call or put option) and let the stop loss kick you out of the trade. You can use this strategy when you want to retain the stock position. You can use this strategy to close your covered call trade after it reaches 90% of your premium, for example, you sell a call with 30 DTE for 1.00 premium, ten days later, the call is worth 0.10 only. There is no reason for waiting another 20 days to capture $10, so close the trade and move on. You do the same with loss protection, set the stop loss to close the trade when the premium is 2x received credit. For example, you collected a 1.00 premium, you close the trade when the option trades at 3.00.


 · Roll it for debit, but…


Sometimes, when the stock and the covered call is not deep in the money and not too deep below your cost basis, it makes sense to roll an in the money covered call for debit. A covered call is a ceiling (cap) to your profits, rolling this ceiling or cap higher gives you more profit potential on the stock. Thus giving up some premium still makes sense. For example, you have a stock that trades at $200 a share. You sold a $210 strike covered call. The stock jumped up to $280 a share. You check the options chain and see that you can roll your covered call from 210 to 250 for 0.30 debit. There is no doubt here, just do it. You will pay $30 dollars to roll but you gain $4000 on the stock profit. You raised your capped profit from $210 a share to $250 a share. And if the stock doesn’t drop in the next few days, you can repeat the process and raise the ceiling higher again. As long as the stock potential profit is larger than the debit you paid, it still makes sense of doing it.

These are all my ideas I apply to my options trading. I do not mind rolling options away in time, higher or lower, adopt additional strategies to help me to dig the option in trouble out of the hole. There is no limit to your thinking. As long, as the trades result in more credit and more income, I do it.
Options are a great tool and you can be playful when using them. Just make sure, your options are protected in some way – either by holding enough cash or have enough shares to cover the trades. Then, you can use whatever you want and options will be safe and rewarding.

Do you know about any other idea about how to trade covered calls when they get in trouble? If so, please, leave a comment below.

2 responses to “Selling Covered Calls below your stock cost basis. What to do?”

  1. Jessica Hernandez says:

    i really like this post about option, am new an i want to learn more

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