Hedge Trading With Covered Call Options
Hedge trading is a way of offsetting the risk of the price of a stock moving in an unfavorable direction. A common options trading method is to purchase a number of stocks and do a short call using the underlying stock as collateral.
Looking for Stocks
When I am looking for stocks sell calls on, I am looking for a stock that I think will either be flat or have slow gains. I do sell them covered, so I already own the underlying stock that I will be selling calls on. This helps protect me from having to purchase the stocks. If there is an upwards gap, I don't want to have to purchase the stocks to fill the contract.
GE is currently a great stock for this because it most likely will continue downward for a while, and I can continue to sell the call options and make a premium income while waiting for it to raise to its former glory.
My overall strategy is to purchase stocks that are flat or slow rising and sell calls that I think will be just out-of-the-money at expiration. I want these stocks to be somewhat close to the strike price.
One important part of this that I have not seen anyone mention before is that you want to be able to afford at least a couple hundred. For most stocks, I look for at least 500 shares. This will offset the increased cost if the option expires in-the-money and you are assigned. TD Ameritrade has a $19.99 for assignments and exercising contracts. I also look for options that expire weekly; this means that they are traded much more and have a high volume.
GE: An Example
At the time of this writing (11/16/2018), GE had plummeted to $8.02, and was trading in the high $7 range for a bit during the day. Personally, I thought it was a good time to jump in, even though some analysts were predicting a low of $5.00. I decided my entry point would be $8.115 for 200 shares. CEO Larry Culp is taking action and consolidating and making movements to improve GE with time. In a few years, if improvements continue, I could see GE going up to the $20's again. Below are several charts using Ichimoku's Cloud.
Down $19 on GE Stock
As you can see on the chart, with the stock I am down $19.00 on GE stock. How I help offset this was I sold two short calls on GE with a strike price of $8.50 and a bid of 10¢. These options expired out-of-the-money and I made $20.00 from hedging this trade. Currently, I have an unrealized gain of $1.00 between the underlying price of GE and the premium I collected from the two out-of-the-money options I sold.
I will continue doing this because the stock may very well dip to $5.00 by the time all is said and done. And I want to protect any gain potential that I may have, but I see GE as being a great buy in the long run.
Looking at the Option Chain
One caution for every trader is not to over-trade. The only guarantee with over trading is that you will pay more in transaction fees. Commission and fees are the bane of all traders, so limit and control this as much as possible to help your bottom line.
If you look at the above options chain, I am focusing on $8.50 for the next couple of weeks. Each week this is something that I review and decide on what strike price I want to focus on. I don't think GE will hit $8.50 for at least a few weeks since it has been trading between $7.80 and $8.20 lately.
For the expiration date of 11/23/2018, the ask is 9¢. The 11/30/2018 $8.50 strike price is 23¢. This is the better purchase, because it is more than double the ask price for the 23rd of November. The short call for 12/7/2018 is 30¢, which is more than 300% over the 23rds. I will not sell at this expiration date because for the additional couple of dollars, I do not want to have to hold this liability for three weeks. I will sell two options for 11/30/2018 for the 23¢ at a strike price of $8.50.
Breaking the Option Down
The premium from selling the two call options will be $46.00. If the option expires out of the money, that is all profit and I decide on the next short call to make. If GE hits $8.50 or more than I still keep the $46.00, and I have to sell my 200 shares at $8.50 a share. I purchased my shares for $1,623 and it was commission-free.
If GE is in-the-money at expiration then here is what happens:
- I make $46 from the premium
- I Sell 200 shares at $8.50 = $1,700
- I pay $19.99 because I was assigned
- So with last week's options and this week's I would profit $113.01
Now I plan on continuing to only collect a premium, but I want to make sure that the miscellaneous fees that brokerages charge don't make me negative on my trades.
For this account, I will continue to collect the premiums and funds until I have enough to purchase cover a short put if it is assigned. I will find a stock that meets my criteria, and then do a short put. If the put is out-of-the-money, then I will complete for the next week and keep the premium and if the short put is in-the-money then I purchased my stocks at a discount.
After that, I will do short calls with that stock the same as I am doing with GE. If I am assigned, then I make money and if I am out-of-the-money then I collect the premium. This is a rather safe method for hedging my stocks, and within six months I should be making several hundred dollars a week from this account.
Investors should be cautious about any and all stock recommendations and should consider the source of any advice on stock selection. Various factors, including but not limited to personal or corporate ownership, may influence or factor stock analysis or opinion.
All investors are advised to conduct their own independent research into individual stocks before making a purchase decision. In addition, investors are advised that past stock performance is no guarantee of future price appreciation.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2018 Chris Andrews