A couple of months ago, I wrote an article about buying garbage.  In the article I explained how I sometimes use options that are so far out of the money that they appear to be garbage.  They appear to be that way because most of the time, when you buy options that are that far out of the money, they end up expiring worthless and it is a waste of money.  Hence the name “garbage”. 

I use the garbage options as a hedge.  They are cheap and serve their purpose.  I’m happy when I lose money on them as I use them for purpose of insurance to the downside.

This week, I will write about how I use cheap call options for the opposite purpose.

Let’s say that you have a covered call.  You sold the call on the stock you own with the thought that the upside move would not happen until after the short call’s expiration.  Now, you are in a position that the stock is moving faster then you thought it would and sooner than you thought it would.

That is one of several situations where this idea may help you.

If the short call that was sold is about 30 days from expiration, and the stock is close to touching the short call, you may want to look to buy a 1 week call with the same strike price.

First, let’s discuss the advantages of having such a position (we’ll cover the disadvantages as well).  The main advantage is that you now have 100% upside on the stock (minus the cost of the call) itself for the week with which you bought the call.  If you are concerned about missing out on upside due to the latest news, chart pattern, etc., this is a way to make the adjustment for the short term of the trade.  The other advantage is that the cost of doing this is often times much less then the cost of closing the original short covered call.  The reason is that it is a shorter time frame for the call (obvious, I know) and the fact that it is likely implied volatility has gone down.  With lower implied volatility, it makes it less costly to buy an option.  We’ve all been there when the call is too expensive to buy back and we sit in front of our screens hoping that the stock will magically stay sideways for 29 more days and then have the upside move.  Most of us have also felt the pain of buying back the covered call and watching the stock go down right after we do it.  The fact that you can buy a shorter term call for much less money is a way to potentially alleviate that pain.

The disadvantage of doing this is the cost of the near-term call.  Yes, it is that simple.  So, the question that you need to ask yourself is if it is worth it.  That is a question that you would have to determine for yourself based on your rules, risk/reward of the trade, and your overall long term financial situation.  One of the main rules that I have is that I only do the trade if I’m fine losing 100% of the cost of the short call.  It must be of that little value.  If I have to think too hard, I simply don’t do it and live with my original results.  I also like to look at using a call spread instead of a call if it is too expensive, but often times, I like to stick to the call.

Finally, this can be done with vertical call spreads and bullish butterflies.  It is not just limited to being done as an upside covered call hedge.

If you are interested in this or anything else that I do as a financial advisor with my clients, please email me at mtosaw@rcmfs.com.