Sunday, October 23, 2011

Covered Call Insurance Rules

One certain way to lose money on covered calls is to close an unprofitable position before expiration. The losses are always magnified.

Rather than taking the loss, I choose to mitigate it by retaining the position and placing off-setting trades against the underlying stock.

It's a form of insurance, paying a premium so that I won't be harmed if the prices of my stock holdings move against me.

The problem of insurance breaks down into two questions: 1) When do I need insurance; I don't want to spend money needlessly, and 2) what strike price and month should I select when buying insurance?

When to buy insurance?

I shall use a 10-day and 40-day moving average cross to trigger insurance purchases and sales.

For existing holdings, if the 10-day moving average crosses below the 40-day moving average, then I shall open an insurance position.

For new holdings, when I open the position, if the 10-day moving average is below the 40-day moving average and is trending downward, then I shall open an insurance position.

I'll use a trailing stop/loss to close the insurance positions, setting it at twice the 10-day average true range above the lowest low attained since the insurance position was opened. Get in a like a turtle and exit like a jack-rabbit.

Now, there are some judgment calls implied by all of this. Sometimes a moving average cross is weak, as when the averages are moving sideways. So, I'll want to treat crosses as a signal only when they show some conviction. I won't define conviction, but I'll know it when I see it.

What strike and month to buy?

The most straightforward sort of insurance is to buy put options. But the straightforward approach raises difficulties, because none of the choices are really good. Deep out-of-the-money puts, with deltas of less than 20, are dirt cheap, but they don't move much when compared to the shares. Deep in-the-money puts can move as much as $1 for every dollar the stock moves, a highly leveraged relationship. But they're quite expensive.

Of even greater importance is the question of time decay. A long option loses value with the passage of time; the technical term is "negative theta". The November at-the-money puts on the exchange-traded fund SPY, at present, lose $7 a day on each contract. And that's not just trading days. It's every day on the calendar. Go out a month to December, and the loss is $5 a day. And of course, the further out the option, the greater the cost.

That level of time decay doesn't sound too awful but it is. An at-the-money put option on SPY goes for $365 per contract, so a $7 time-decay hit works out to 1.9% per day, or 57% per month. Annualized the daily loss works out to 694%, an usurious rate. Inflation, stock-market crashes, interest on Greek bonds -- they all pale in significance in comparison to relentless time decay.

An alternative would be to sell bear call spreads. The position consists of selling a call option, and then buying one that's further out of the money. The net position is short. That means you get money up front because you're selling, and time, rather than causing the value to fall, instead causes it to increase. Theta, in other words, is positive. And as a trader, I've learned to love positive theta as way to increase my edge in the markets.

The trade-off is that the spread limits the profit. The limit can be controlled by adjusting the strike prices of the spread.

So under my new rules, I'll sell near-term bear call spreads for insurance against declines, with the strike prices both above the current price (a conservative strategy).

One characteristic of spreads is that they have very little movement in relation to the stock -- "low delta" is the term of art. One way around this is to sell spread contracts at a multiple of the covered call contracts in the portfolio; e.g., 1 covered call contract and 5 bear call spreads.

Insuring Lost Opportunity

A covered call limits the profit on the underlying stock to the covered call strike price. So, a rising stock represents a missed profit opportunity for the trader. To insure against that lost opportunity, I'll open insurance positions against my holdings when the 10-day moving average is above the 40-day moving average. Instead of bear call spreads, I'll use bull put spreads.

For the perplexed...

Here's some recommended Wikipedia reading for anyone needing to catch up on covered calls and vertical spreads, such as bear call spreads and bull put spreads.

Covered Call.

Bear Call Spread.

Bull Put Spread.

About my trading methods

Read a detailed explanation of my analysis method, including trading rules.


Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.

No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.

The trader’s greatest sin is inaction. Sleeper, awake! Seize the Nietzchean moment. Roll out of bed and trade.

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