Adjusting Covered Call Campaigns: 10 Easy Ways to Maximize Profits & Reduce Risk

Covered calls are a popular and easy-to-understand investment strategy that combines the benefits of owning an underlying asset such as a stock or cryptocurrency such as BTC or ETH, with the potential income from selling call options against it.

A covered call campaign is simply the consistent selling of calls against an underlying asset for a (usually) extended period to drive consistent returns.

While this strategy can be an effective way to generate consistent income, adjusting covered call campaigns is often necessary in response to changing market conditions.

Adjusting Covered Call Campaigns: Why Do It?

There are two primary scenarios that would call for adjustments to a covered call campaign.

1. A rise in the price of the underlying asset:

If the underlying asset’s price rises significantly and nears or surpasses the short call strike price a decision needs to be made whether or not to manage that option.

In the case of a stock, there’s a risk that the stock might be called away (i.e., the call option is exercised), resulting in missed gains if the investor or trader remains bullish on the stock’s potential.

In some cases, where the investor or trader thinks that the outlook is bearish or they’re okay with no longer owning the underlying stock, they may be perfectly happy to allow the stock to be called away.

2. A decline in the price of the underlying asset

When the underlying asset’s price declines, the premium received from selling the call option may not completely offset the loss in value of the underlying asset. In this case, making an adjustment can help mitigate potential losses.

If one has been running a covered call campaign for a period of time, it’s important to understand that with each successful cycle of selling a call option, the cost basis of the underlying is reduced.

Adjusting can happen at any time during the life of an option. For many traders and investors, they’re often more concerned about adjustments as the option nears its expiration where the price of the underlying asset will either be in-the-money (ITM) or out-of-the-money (OTM) and making any required adjustments in response to either scenario.

When talking specifically about stocks, for the most part, assignments do not occur until the last week of expiration. One important exception to this concerns dividend payments.

If the underlying stock is going to pay a dividend, the short call is at greater risk of assignment if it is ITM because the long call holder may wish to exercise their right to buy shares of the stock in order to collect the dividend.

Adjusting a Covered Call

There are a number of ways in which we are adjusting covered call campaigns in order to optimize returns and manage risk (hedge). Here are 10 of the most common adjustments that we utilize.

1. Rolling Up:

Rolling up refers to price. If the underlying asset’s price rises significantly and nears the call option’s strike price and the investor wants to mitigate the risk of having the underlying asset “called away” (forced to sell it at the strike price), he or she can “roll up” the call option.

This means buying back the current call option and simultaneously selling a new call option with a higher strike price.

We would normally want to do this for a net credit or possibly as a “flat” trade. Essentially, we’re buying ourselves more space in which to be right, keeping the option strike price higher than the underlying asset price, capturing most if not all of the premium.

In the case where it’s not possible to roll the position up for a flat or credit, we’d then look at opportunities to roll out, or up and out (below).

2. Rolling Out:

Rolling out refers to the time to expiry. In the same scenario as above where the underlying asset’s price nears or surpasses the strike price, the option can be rolled out. This entails buying back the current call option and selling a new one with a later expiration date but with the same strike price.

A trader or investor would do this if they thought that the price of the underlying asset was likely to decline in the near term and prior to the expiry of the new call option being sold.

Rolling out can be thought of as giving ourselves more time in which to be “right” and extending the time frame for potential price appreciation while collecting more premium.

3. Rolling Up and Out:

Rolling up and out is probably the most common adjustment action when rolling. It involves buying back the existing short call option and then simultaneously selling a new call option at a higher price and further out in time.

When buying more time and price leeway, it’s far easier to roll for a net credit or flat trade.

4. Rolling Down:

Rolling down is something that can be considered when the underlying asset’s price falls. To roll the option down, the existing short call is repurchased (for less money than it was sold), and a new call is sold with a lower strike price that is closer to the underlying asset’s current price.

The increased premium received helps offset the downward movement of the underlying asset, but at the same time lowers the upside potential gains in the underlying.

One can of course roll down and out as well, meaning rolling down in price and out in time.

5. Collar Strategy:

In volatile markets where investors are unsure of future price movements and fearful of the underlying asset declining in price, a collar strategy can provide some amount of downside protection. It involves using the proceeds from the sale of the call option to simultaneously purchase a protective put option.

For stocks, the put option gives the buyer the right to sell the stock at a predetermined (the strike) price. This limits potential losses on the downside while capping gains on the upside.

6. Ratio Writing:

Ratio writing is something we do when we’re confident about the underlying asset’s short-term price movements, where we write more call options than the amount of underlying being held.

This generates extra revenue, but the extra calls sold are “naked”, increasing exposure to risk and the possibility of potential losses if the underlying price experiences a significant price increase.

7. Unwinding:

If the underlying asset’s price has a significant decline or one expects it to, unwinding or closing the covered call may end up being the best course of action.

To unwind a covered call, the call option would be bought back and the underlying asset sold. Oftentimes, the trader or investor would then wait for the opportunity to re-purchase the underlying at a lower price and start the covered call campaign again.

8. Adjusting Position Size:

Depending upon market conditions, traders or investors will adjust their strategy and either sell fewer or more (ratio writing) call options. This flexibility allows for greater customization in accordance with an individual's risk tolerance or market outlook.

9. Long Call Spread Strategy:

If a trader or investor had a very bullish sentiment on an underlying asset, they could use the proceeds from the sale of the call (plus additional funds if desired) and buy call options creating a long call spread. This is quite aggressive, but the long calls would have limited risk and unlimited reward potential.

10. Splitting The Risk Strategies:

Splitting risk is something that we do frequently at Rogue Trader Academy. There are a number of scenarios where we find this to be appropriate and comfortable. It’s essentially rolling the covered call into a short strangle, iron condor, broken wing iron condor, etc.

Further, we may not necessarily evenly split the strategy, sometimes preferring to allocate more contracts to one side or the other depending upon market conditions, skew or bias.

In the event that one side is tested (only one side can be wrong), comparatively, there’s half the risk to manage.

Note that when making any type of adjustment, there’s no need to wait until near expiry before doing so. If there’s a significant change in the price of the underlying asset or the price of the option, a trader can make an adjustment at any time during the life of an option.

If for example, a 30-day covered call was sold as part of a systematic program, and during a particular 30-day cycle the price of the option dropped significantly with 15 days left to expiry, a trader may choose to buy back that option, locking in gains.

At that point, if the trader wanted to get back onto the “schedule” he or she could either sell another call that expires in 45 days or wait 15 days to sell another covered call.

Factors Influencing Adjustments

Each investor will have their own goals and circumstances, but generally speaking, adjusting covered call campaigns will usually hinge on these factors:

1. Price movement of the underlying asset:

As detailed above, significant price moves in either direction often necessitate adjusting covered call campaigns in order to lock in gains or reduce risk.
The best practices for rolling are when calls are near or ATM, as the underlying asset’s price approaches the strike price. When the price gets ITM, it’s more challenging to roll the call for a net credit.

Further, when a covered call is ITM, the risk profile is the same as a short put. Some traders and investors may choose to halt the covered call campaign and convert the position to a short put, especially if doing a standard roll is difficult to achieve due to option prices and/or liquidity.

Covered call vs. short put risk profile

2. Volatility:

Swings in volatility will normally lead to larger price swings. In these conditions, adjustments may be more frequent in order to capitalize on opportunities and reduce risk.

3. Time to Expiration:

As the option expiration date approaches, the need for adjustment might change. Closer expirations often require more immediate actions, while longer expirations offer greater flexibility.

4. Market Sentiment:

Monitoring market sentiment and the volatility surface can aid in making adjustments.

5. Earnings Reports & Economic Events:

Earnings reports, dividends, other corporate events, and broader economic events such as FOMC meetings, etc., can significantly impact the price of the underlying asset and affect option premiums due to uncertainty.

There are a host of strategies that can be deployed to take advantage of or defend against these events, but in regards to covered calls, traders will often make adjustments prior to such events to avoid unexpected surprises.

Conclusion

Adjusting covered call campaigns isn't always required, nor does every trader choose to make adjustments. Adjusting any option strategy requires an understanding of the strategy itself, market dynamics, and risk management.

While there are never any guarantees in trading and the markets can be completely unpredictable, we find that erring on the side of caution by taking profits when they’re available and hedging downside risk helps us to be better traders and sleep better at night too.