Educational Strategy Reprints

Managing a Covered Call Portfolio

A covered call portfolio is more complicated to manage than a stock portfolio, but a few simple calculations and basic guidelines can make its management a whole lot simpler. This week, we show how to decide when to hold your covered call, when to roll the call and when to close both the stock and the call. (This report is a revision to Chapter 9 of The Value Line Guide to Option Strategies).

Why a Covered Call?

Covered call writing is a bullish, premium selling, strategy. That is - you write a covered call because you expect the stock to go up and because you believe the premium is overpriced. By writing the call and collecting the premium, you give up some of the stock's upside potential, since you agree to sell the stock at the strike price.

The Value Line Daily Options Survey ranks covered calls based on a combination of the common stock rank and the degree to which our option model calculates the call to be overpriced. Attractive covered calls can be found anywhere on a continuum running from higher-strike out-of-the-money covered calls that are aggressively bullish and offer only a modicum of downside protection, to lower-strike in-the-money covered calls that offer substantial downside protection but virtually no profit potential beyond the time value of the call.

At present, most of the rank 1 covered calls that our model has picked are lower-strike in-the-money calls. This is due to the investing public's recent penchant for overpaying for lower strike options rather than the result of any bias on the part of our model. (See "Volatility, a Long-Term View," Ot060807.Pdf in our Options Reports Archive.)

Looking at Your Portfolio

Whether you initially write a covered call that is at-the-money, in-the-money or out-the-money, you do so because the combined position offers you an attractive package of potential for profits and downside protection. However, as time passes, and the stock and the call change in value, your covered call can either loses its potential for gains or its downside protection. The trick to managing a covered call portfolio is to monitor your positions and look for signals as to when it is time to roll or to close your positions.

Look at the calculations in columns H through K in Figure 1 on page 3;

H. The maximum profit potential,

I. The annualized return if there is no change in the stock,

J. The downside protection (the % the stock can fall before a loss would result), and

K. The "profit protection" (the % the stock can fall without reducing the original profit potential).

To make the calculations shown for your own portfolio, you can use these equations at the bottom of the table. We also include most of these calculations for all calls in our service. (See "Tracking Your Covered Call Portfolio," Ot051226.Pdf.)

Notice that we use the current cost basis (stock minus premium) of the covered calls, not the original cost basis, as the basis for most of these calculations. (If you want an excel version of Figure 1, you can email us at vloptions@valueline.com.)

Simply cast your eye down these columns to see which positions deserve your immediate attention. As you look at columns H, I, J & K, you can see that two positions, Allegheny Energy and DirectTV, offer annualized returns of less than 1.0% (while the going rate for a money market account is around 4.0%). Also, note that one position, Archer Daniels, offers a better than money market yield but downside protection of only 0.6%. These three positions are the ones we may wish to act on.

• Allegheny Energy is clearly ripe for rolling. It has practically no time premium to collect. The position offers an annualized return over the six weeks until expiration of only 0.9%. It is time to roll out of this October $30 call into another call that offers a more acceptable annualized return. (At the time of this writing, the rank 2 January $40 covered call offered a 16.0% annual yield and downside protection of 6.9%. If you want a higher yield, you may want to close the position out and open another on a different stock.)
  
  
• Our position in Continental Airlines is still quite attractive. It has excellent downside protection relative to the time to expiration and promises a tempting 37.5% annualized return and 18.2% downside protection to its breakeven price. Moreover, the stock can drop 10.9% within this period and we would still earn the full return. (See profit protection in column K.)
  
  
• Akamai Technologies is also in good shape, considering that it expires in 43 days. It offers a 27.6% per-annum return (column I), downside protection of 18.2% and profit protection of 11.2% (column K).
  
  
• The out-of-the-money covered call on Cognizant Technologies has more than four months to run. It offers a 15.2% annualized return and downside protection of 5.1%, both of which are perfectly acceptable. Moreover, it offers a maximum profit of 14.6%. This is how much you would make if the stock ended up at $75 or above, on January 20, 2007.
  
  
• The out-of-the-money covered call in DIRECTTV is another story. Its premium has dwindled to only five cents, and it now offers only a 1.0% per-annum return. One might consider rolling down and out to the $17.0 strike January call that offers a per-annum return of 10.1% and downside protection of 12.9%.
  
  
• The Advanced Micro Devices October $19 covered call has moved sharply in-the-money and is now yielding 8.9%, with 26.6% worth of downside protection. Although its profile is attractive, one might consider rolling this up and out to January $22.50, which yields 30.7% and offers 17.10% worth of downside protection
  
  
• The last position in Figure 1 is Archer Daniels Midland. It offers a maximum profit of 13.4% and a slightly better than money market return of 5.5%. However, its downside protection is only 0.6%. One probably would want to take a more defensive position with this covered call such as rolling it out to the December $40 strike at $2.80, which offers a per-annum return of $30.6% and downside protection of 7.0%, or the even more conservative $35 strike at $6.00, offering a 12.1% perannum return and downside protection of 15.0%.

Note that your decision to roll a covered call (as opposed to closing it out entirely) should depend on a combination of your current outlook for the stock, on the covered call's returns, and on the downside protection that the covered call offers. When looking at a particular covered call, you should seriously consider whether the underlying stock position is worth keeping and whether current premium levels warrant writing calls against the stock.

Prepared by Lawrence D. Cavanagh,
Editor, Value Line Options
vloptions@valueline.com