What to do When Your Covered Call Writing Strategy Goes Bad

Most investors usually consider only two choices:

1. Dump the stock, take your loss, and move on. This is a reasonable choice when you believe that the stock has been so badly damaged that it will not recover for a long time, during which you will be holding it with no option income, tying up your remaining funds in a no-win situation and possibly incurring even greater losses as the stock continues to fall.

2. Hold on and hope the stock will recover so you can at least "get out even".



Most investors usually hold on and hope. But eventually many of them give up and sell. So let me suggest a third choice:

3. Dump the stock, and sell more shares short immediately.

By selling right away and quickly selling short as well, you might be able to cover those shorts at a profit when others finally give in and sell (to you) at substantially lower prices.

In this way, you took a lemon and made lemonade, by being humble enough to admit you were wrong, and having the guts and flexible trading skill to take decisive action to fix it.



If you really still believe in the stock, you could also make a fourth choice:

4. Buy more and sell covered calls on the new shares at a lower strike price than the first time. Then you could hope that as the stock recovers, you can make even safer profit on the new shares (since you bought them cheaper) and maybe they'll get called away as well, giving you some gap capital gain as well as option income. Then when your original shares are back near where you started you can resume selling calls on those at the original strike price.

But my own preference, if I still like the stock, is usually not to buy more shares, but instead make a fifth choice:

5. Sell some naked calls to hedge.

For example, if I originally bought 200 shares which tanked, I'd leave the original two covered calls to expire but sell, say, four more, for a total of six. These would be naked calls, but the risk is only that the stock shoots back up, which is what I want. In the unlikely event that happens I can have buy stops in place on the way up to gradually and automatically turn some or all of the new naked calls into covered ones by purchasing additional shares of stock.

In the more likely case, the additional calls will also expire worthless. It usually takes much longer for a stock to recover than investors expect, and during this waiting period, as more investors give up and dump their shares, providing overhead resistance, at least I get some extra income to compensate me.

When I sell naked calls in this type of situation I typically choose a lower strike price and/or more distant expiration date than the original covered calls, for the obvious reason that the original ones are probably not worth much at this point.

Selling more calls than are covered by underlying stock is called "ratio writing". Here's a good article with a detailed real-world example.