As we all know, there are various ways to manage a position. Up down or sideways, whatever the market does, most are pretty easy to manage. Except the one when you sell calls underwater and risk assignment at less than your cost basis. Fortunately it doesn’t happen too often, but we just had six weeks of down market and just about everyone is underwater by now.
I’ve been working this one for a long time and finally have a satisfactory answer. I was determined to figure out how to make premium each and every week, no matter where my position was or what the market was doing. I traded emails with Alan Ellman (Blue Collar Investor) about this and he said something that clarified my view. He didn’t actually have a good answer, but he gave me the insight to figure it out. He handles this two ways; either he jumps to another stock or he does a “stock repair strategy”. Well, jumping from stock to stock seems too erratic. If the whole market is going down, so will whatever you try to jump to. Not for me. The “stock repair strategy” is just adding a call spread to your trade. Well hell, if you’re going to trade spreads, trade spreads. Don’t add a complex trade to an already losing one.
However I think there is a way to manage this one that’s successful.
Let me use a recent example to explain. I’m in IWM at 207, the last price I was assigned. IWM went down to 177 and I sold 182 calls, using my 85% POS rule. Got away with that for weeks but finally IWM popped up and now I’m looking at getting assigned at 182, far lower than my 207. (I do not take into account any premium, I prefer to only look at cost basis.)IWM is at 185. If I let myself get assigned and promptly buy IWM back on the next trading day at 185, I’m down three dollars per share, or $300 a contract. However, if I roll on expiration day up to 185, that costs me .56 cents per share, or $56 a contract. Much better, and either way, my new strike is 185. So by spending .56 cents I have retained the intrinsic price gain of $3.00. A loss, yes, but one that I can make up in one trade. When the difference between stock price and my strike price is smaller, the cost to roll goes down and can be flat or even positive. Going out in time a few more days helps there. Lately I’ve been selling two day trades, selling on Monday for Wednesday expiry and on Wednesday or Thursday for Friday.
And since I’m using the 85% POS strike when I sell these underwater calls, the times this happens and I have to incur a cost to roll up or out are far fewer than the times my trade expires successfully and I don’t have to worry about it. Of my last 14 trades, I had to roll 2.
If the strike is very close to the closing price at expiration, then there’s no need to roll and the method of letting assignment happen and buying right back in the next trading day works just fine.
In both cases, there is a risk of having to spend some money to stay in the game. That’s what I was missing when I was trying to figure this out, I was looking for a fool-proof method. There ain’t one. But if I can generate premium while a position is far underwater while I ride it back up, and if overall, the hits outweigh the misses, I’m happy. There is even a term for this, it’s called “strategic mediocrity.” Hitting lots of small wins to make up for occasional losses. This does work better the closer you are to the money, like any option trade. A stock that shot up dramatically in a short time might really sting. But IWM doesn’t do that so I feel ok doing this.
I remain confident that the market will recover and my IWM will get back to 207 and above, at which point I’m back in regular selling mode. Meanwhile, I’m making some premium.