Papale on Selling Calls as a Hedge

By Steve Papale

Last night I watched a show with my kids I had never seen before called “Extreme Cheapskates”.   Now I’m all for saving a dollar.  So for the frugal readers here are few ideas to save some money people are using.  Floss with human hair.  Yep one lady actually flossed her teeth with human hair to save on dental floss.  Must be some strong hair.  Wash your clothes and dishes in your hot tub.  While relaxing in the hot tub might as well clean stuff.  Buy one latte and make it last all week.  The paper cup can get pretty nasty but you save a couple bucks.  I think I’ll stick to working and doing these things the normal way.  I doubt I’ll ever be able to get into a hot tub again.

Selling calls can be a nice way to hedge some of the risk in selloffs such as what we have seen in the last week.  By selling a call, the seller effectively lowers his cost basis by the amount of premium taken in.  If the stock sells off hard, the call can be bought back and a new call can be sold again to collect more premium.  A sound strategy; but like all strategies there a few things to keep in mind.

First, when stocks fall hard IV goes up.  And when we see extreme moves like we saw this week, IV can go up a lot.  In the last week, VIX has gone from the mid teens to near 30.  No surprise there.   If you are short calls against stock you may find your calls may not drop in  price as much you might expect.  This is due to the increasing IV pumping more premium into the calls, offsetting the declining effect of falling stock prices.  This effect is more pronounced when there is more a week until expiration or so but still in the front month or two.

Remember that vols increase the most in the front month and less as we move out in time.  So those short calls may be holding their value a bit more than you might expect and not helping your bottom line as much as you would like.  This could prevent you from rolling the calls as soon as you might otherwise.  If you do roll calls down (buy the short cheap call and resell another closer to at the money) watch out for the bounce effect.

Stocks may have a violent bounce back from oversold conditions.  If you sell a call at a lower strike you will limit your ability to participate on the rally.  These decisions come down to individual preferences based on market outlook and capital preservation.  This is a good environment to sell calls against long stock, just know the factors affecting the call going into to trade.

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