How to Manage a Winning Covered Call

The Short Call on Your Covered Call is ITM: Here’s What To Do

• The covered call is a great beginner options strategy, as it combines the familiarity of stock with the newness of options.

• A winning covered call that is more of a “trade” is an easy position to manage, as closing the trade is usually the move to make.

• But a winning covered call that is more of an “investment” is trickier to manage and requires a more detailed analysis of the assorted options.

The covered call is a great options strategy that is often overlooked in the world of active trading.

Not only is the covered call a great strategy for beginner option traders, but it also serves as a natural bridge from stock to options. By combining the familiarity of long stock with the novelty of a short call, newer traders can slowly wade into the world of options, rather than diving straight into the deep end.

Trade or investment?

When it comes to managing a winning covered call, you first need to establish your overall objective. For example, is your covered call a short-term, active trade, or is it more of a long-term investment?

More than most other options strategies, the covered call is often used on passive, longer-term holdings, to bring in a source of profitability that isn’t directly tied to stock price performance or dividend payments. Therefore, an in-the-money (ITM) covered call is a shorter-term trade, and the management is easy—you simply close it.

It’s a good trade. The stock did what you asked it to do. So, you close the position and move on.

A more challenging situation involves having a winning covered call on a position and treating that as an investment.

ITM short calls on passive covered calls

How do you handle a passive covered call when the stock runs past your short call strike? It depends on your goals for your total portfolio, along with how profitable the overall position is.

The remarkable thing about short options is you can always roll out at the same strike and collect the additional extrinsic value that comes with adding duration to that short strike. This can be a great strategy if the stock is only slightly above the short call, and there is still a good amount of extrinsic value in the strike you’re holding. Doing this, you will be giving up any stock price gains above the short strike, but if the extra extrinsic value collected is significant enough, it can be a worthwhile option to consider. 

But what happens when the stock runs up so far that your short call is now deep ITM? This is trickier to manage.

You could simply roll the same strike out in time, like a scenario where the short call is only slightly ITM. But it's likely that the extrinsic value will be meager, given how deep the ITM option is at the time. Therefore, a better option in this specific situation might be to consider rolling the strike out in time, but also up closer to where the stock price is.

This will likely cost a debit to adjust, but that debit can be worth it, if you reclaim a nice chunk of the intrinsic value you had to forfeit on the ITM short call. For example, you roll an ITM short call out to the next cycle and up $5 in strike price for a $2 debit.

Yes, the $2 debit must be added to your basis on the trade, but you just gained back $5 of intrinsic value you would otherwise not be able to access. Thus, the net benefit is a positive $3 to your profit potential on the trade.

Jim Schultz, a quantitative expert and finance Ph.D., has been trading the markets for nearly two decades. He hosts From Theory to Practice, Monday-Friday on tastylive, where he explains theoretical trading concepts and provides a practical application of those concepts to a trading portfolio. @jschultzf3

Thomas Westwater, a tastylive financial writer and analyst, has eight years of markets and trading experience. @fxwestwater

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