Why Cover Calls Make a Down Day a Little Brighter
Selling cover calls on your stocks is a conservative position for your portfolio, a position that at times can be very frustrating. Nothing is worse than watching your stocks rise, but your cover calls negating many of the gains. Imagine you have 100 shares of a stock at $34 a share and you sell an option at a strike price of $35. The stock rises to $36 a day later and suddenly you are regretting your decision to sell a cover call.
Most brokers show any cover calls as a negative equity position (example shown below in the red box). The amount of negative equity is equal to what it would cost you to buy out your option, so therefore if the stock goes up the option will cost more to buy back. Your account might say you gained $200 on this stock, but your option is now –$100 more, effectively counteracting your gains on the stocks.
It might be discouraging if the stock is on the rise, but there are two ways these options can quickly become your friend. The first way is your option will lose negative equity, is the passing of time. As the option comes closer and closer to expiration, the cost for you to buy that option out will decrease. The second way the option will lose negative equity is when the stock deprecates (like in example above). My position in Dow Chemical took a $57 hit on Thursday, but this was counteracted by my cover call to negative almost half of the loss.
This is why you sell cover calls on your positions, to offer you downside protection. It is easy to lose focus on why you sell cover calls on your stocks while stocks are rising, but easy to remember when they are falling. That is why cover calls definitely make a down day a little bit brighter.
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