Weigh Up Trading Strategies for Writing Calls - dummies

By David Stevenson

The really big problem with the trading strategy of writing covered calls in the UK and around the world is if the share price collapses, dropping below your break-even point in the process: at what point do you bail out?

Your alternatives when a share falls below its break-even point are:

  • Sell the shares, but keep the call option open, turning your covered call into a naked written call. Now you’re potentially on the hook for unlimited losses if the share unexpectedly sky-rockets and your options broker therefore requires you to lodge a deposit. Converting to naked call writing in this way isn’t a recommended course of action for most people.

  • Exit the position in its entirety, selling the share and buying the option. But this action is undesirable because you have to pay something to purchase the option, increasing the hit you’ve taken on the value of the share.

  • Take the risk of accepting the loss and writing calls on the share for the next month to help make up for any losses you make. This choice can be successful if you manage to build up a small nest egg for those periods when the market moves against you.

Make sure that you remain aware of the dates when the shares you own go ex-dividend (the date at which the dividend goes to the person who bought the security rather than the person who sold the security).

This event skews the premiums for call prices and you lose out if you don’t hold the shares on the payment date. In a situation where the market is trending lower, you may want to think about reversing the strategy and look at trading covered puts — where you look to purchase the shares.