While I was in Canada last week, Smart Profits readers sure did pound the mailbag! I returned to find several questions to my recent column on how to execute covered call trades.

For example, one reader wanted to know how options can work with short positions – and referenced doing so on Yamana Gold (NYSE: AUY).

Here’s how…

In this case, I’m assuming that you’re short on Yamana and are trying to manage the position in order to not take a big loss in case it moves against you.

The way to do this would be to buy out-of-the money call options to protect you against any sharp moves up. This is like insurance. You’ll lose a little bit of money, but your downside will be capped once the option goes in-the-money.

The problem here is that if Yamana trades sideways, you’ll lose on the call option and would have to buy more as each one expires. The way around this would be to buy a LEAP call option, but it will be more expensive and eat away at your potential profits.

But what if you want to “go deep?”

Buying Short-Term Options Is A Sucker’s Bet

Here’s another question:

“Please explain the benefits of buying deep-in-the-money options.”

The buyer stands a lesser chance of benefiting than the seller, since the underlying shares must rise in order for the buyer to make money.

On the other hand, the seller can either have Yamana stay at the same price, move up, or move down to make money. Just as long as it’s not by more than his cost.

So what prompts buyers to buy options? Simple… they’re gambling and wish to spend a little bit of money, as opposed to buying the shares. They’re betting on a strong move up, but will unfortunately lose out 70% to 80% of the time. That’s why we don’t buy short-term options. Because doing so is basically saying that we can predict where Yamana will be by expiration in a few weeks or months.

What To Do When Your Options Expire

Finally, here’s another question – a two-parter:

Part 1: Whenever I read about covered calls strategies, there never seem to be much information of what to do after expiration. For example, if the shares get called away or increase in share price, do we buy the same shares again? And do we still sell deep-in-the-money calls then?

It depends on your goals. For us, when we’re using the deep in the money strategy, the objective IS to get called away every time since we are looking to own the shares at lower levels. However, if you’re looking to own the shares and continuously sell calls, then you would buy back the calls the day before expiration, taking advantage of all the premium you have captured from the expiration of time value and volatility. Then you would sell another option with either a higher strike and further out. This is called “rolling” your trade.

Part 2: If the shares don’t get called away, due to a drop in the share price, do we sell covered calls again, except at a lower strike price in order to get a good premium? Or do we sell out-the-money calls now (but the premium is lower).

With the strategy we use, we always try to sell options at the same strike price. So if the shares are lower than the strike price and we hold on to them, we’d then sell options at the same strike price and lower our cost even more. Our goal is to own the shares for zero or negative cost.

If you want to go out-of-the-money, you’re now engaging in a pure long strategy, which is not the goal of deep-in-the-money investing. The worst case is that the shares fall well below the strike and your cost. In this case you can either book the loss, or if you’re investing in a very good company, you just hold the shares until they recover. This happens about 20% to 25% of the time.

This is also the reason why you should only invest in companies that you truly do want to own… because sometimes you’ll end up owning them.

Good investing,

Karim Rahemtulla
Smart Profits Report