Before I ever write a covered call, I make sure that I would not mind parting with the stock at the strike price. I usually only write them on stocks that have gone up a lot in my portfolio, that I still think have good longterm appreciation potential (meaning that the company is still doing well at their business and have room to grow), but that have gotten too pricey for their current value.
For example, I recently wrote some covered calls on BJ’s Restaurants International. I had bought the shares at somewhere around $20, I thought the stock was expensive at $45, but then the price continued to climb to around $60. With a PE approaching 50, it was clear that although this is a great, growing company, it will take a while for earnings to justify the high price. Rather than wait around for earnings to grow, I decided to write some covered calls and gain an income from the stock.
As it happened, the stock did go higher, and as expiration date approached it was a couple of dollars above my strike price. (Note, options can, but almost never are, be executed before the expiration date. Typically, however, they are executed just before expiration, so you are usually safe to wait until at least the week of expiration before taking action.) In this case I analyzed the stock price and decided that I would not buy the shares at that price, so why should I close the position and effectively raise my cost basis. I decided in this case to go ahead and let the shares be sold. I bought back part of the position a few weeks later for about $10 less per share.
If I had decided that I didn’t want to lose the shares – for example if doing so would trigger a tax bill I didn’t want to pay, or if I would probably just buy the shares back at the current price and the cost of commissions for buying back the shares exceeded the cost of trading options, I might close the option position by buying an offsetting call option. While this might cause a loss (depending on the premiums you collected when you wrote the calls and how far above the strike price the stock is), you are generally trading cash for the stock at a higher price. In other words, you are increasing your effective cost basis on the stock.
For example, supposed you sold Jun $50 calls on XYZ corp and the stock went to $52. Near expiration, the price of the call would be somewhere around $2.10 – the difference between the current stock price and the strike price, plus a small premium for the remaining life of the option. If you were to close the position by buying an offsetting Jun $50 call, you would be paying $210 per option plus broker fees. If you sold the calls originally for $1.20, you have now increased the amount you have in the stock by $2.10 – $1.20 = $.90 per share. Note that the stock is also higher in price, so you really didn’t lose the money (yet), but you are increasing how much you have in the stock. You should therefore ask yourself if you would buy the stock at the current price. If not, let the stock be called away. If so, then cover the position.
Another thing that can be done to offset the loss is to “roll the option” to a higher strike price and a later expiration date. In our example, let’s say that you see the August $53 call is selling for $1.50. You could close your Jun $50 calls and write an August $53 call. This would increase the price at which you would lose the shares, giving you another dollar of breathing room, and the $1.50 in premiums you would collect would offset the price you are paying to close out the position. Note there is a slight risk here that your existing option could be executed before you close the position, particularly if you are very close to expiration. In that case you could end up with a naked call rather than a covered call – a very precarious position. It would be a good idea to verify with your broker that you have not been assigned an execution before writing the new calls.
Finally, there is another reason you might wish to close the position. Because a written call looks like short interest in your account, a stock that has gone up far above the strike price may cause your account to go into margin. You are then paying interest and are possibly subject to a margin call even though the increase in the stock price will offset the loss on the call directly. If this is the case, and it is a while until expiration, the best strategy is to close the option position and sell the shares to make up the deficit rather than waiting for the option to be executed.