This may surprise you, but I believe one of the best things that can happen to a brand-new trader is to take a loss.
Don’t get me wrong. It’s great to win, like we have, and be profitable on your first trade, first five trades, or even your first 10 trades. But an immediate winning streak like that may be setting you up for disappointment later.
Too much success can give new traders an overinflated amount of confidence. You start to think that trading is easy and there isn’t much to it. That whatever you used to choose the winning trades is ALL you will ever have to use; that you found the magic bullet to trading success. You start taking more and more risks… and then disaster.
Look, I can speak to personal history that all I have mentioned is possible… because it happened to me when I started out.
I look back and think if I had suffered a loss or two or more to start, I would have had to learn earlier what it takes to manage a trade when it goes against you.
That’s what I want to show you today, with a follow-up on the GMCR covered call idea.
Let’s Review the GMCR Covered Call Trade
Last week I showed you a covered call idea on Keurig Green Mountain Inc. (NASDAQ:GMCR) I showed you last week, and it didn’t work as expected.
After announcing earnings on August 5, GMCR dropped from $74.98 to open at $53.92 the next session. The way the stock got hammered, you would think GMCR was a pharmaceutical company. It’s common to see pharma companies have this kind of dramatic price move post earnings if they miss – especially on pharma stocks $10 to mid-teens in price.
But this was a 25-30% hit on a $70+ stock.
Plus, it wasn’t so much that GMCR’s earnings were bad or missed; it was their report on revenue and forward guidance.
When a trade like that comes along, though initially painful to see the loss in stock price, there is an opportunity to use this situation to work on your trade management skills, thereby developing your skillset to becoming a more accomplished trader.
With GMCR, let’s take this opportunity to learn these lessons and develop that trade management skillset now.
We’re in the Second Scenario – Here’s the Situation
I outlined two scenarios in the previous covered call article on GMCR. In one, you get called out; in the other, you don’t.
Here is what I said:
The thing to ask yourself is are you going to be ok with owning GMCR if it goes much lower than it currently is before the report. If so, stay with the strategy and know that you can keep utilizing the covered call strategy at lower stock prices to try and recoup any losses in stock price.
GMCR did drop, so here is the situation so far on the option (prices as of Friday afternoon):
Now the likelihood of getting called out at $80 is virtually non-existent.
One way a trader in this situation – where the stock was bought and a call was written on it – can get out of the trade is to buy back the option to close that obligation. (Remember, when an option is sold-to-open, the seller is obligated to deliver the stock if need be.)
Once the call is bought-to-close, the trader can then decide to wipe their hands of the stock and sell it for current market price.
In this case, however, the price dropped so low that there is no value in the GMCR Aug15 80C options, so you really can’t buy this option back right now. You can place a GTC (Good til Canceled) order for a $0.01 buyback, but don’t expect it to be executed.
This means the writer of the call will be holding this stock until expiration of the contract (unless that buyback, by chance, happens).
You always have the option to buy more stock to reduce the basis in the stock, but that is not what I am advocating here.
If You Own the Stock and the Call…
Let’s stick with the mindset that one still owns the stock with the call option out there on it. Let’s look at the cost basis on the stock as it currently stands.
The stock was shown at a purchase price of $76, but with the call option written or sold against it, the cost basis is reduced by the premium taken in by that option premium amount or $2.67. The basis is currently $76 minus $2.67, or $73.33. Not much consolation with a stock trading at $54, but again, this was only to be considered on the stock if you did not mind owning it should a drop in price happen.
So what next?
Come expiration next month, the option will have expired, the stock will still be in your possession, and you’ll have the opportunity to evaluate the options around the current stock price at that time – and sell if you wish. This would bring another premium amount to the account, further reducing the cost basis.
If the stock gets called out on any subsequent months, you could either buy back into the stock and try the covered call strategy again, or just move on to other trades.
The more options sold, expired worthless, and stock kept can reduce the basis enough that GMCR doesn’t have to come all the way back to $76 to break even.
How the Covered Call Strategy Can Reduce Your Loss Down to Nothing
This stock is in a loss situation, whether you just own the stock only or have done the covered call strategy on it.
But here’s the difference between the traders of the covered call strategy vs. the long-term investor…
The long-term investor is stuck with the full loss if they decide to sell.
The covered call writer, who at least brought in some premium to the account and can continue to do so if they choose, reduced the amount of their loss by using this strategy.
For example, let’s take a look at current GMCR options now that the stock has dropped…
Right now options that are 5% above the current strike price are selling for $2.46. That means you could collect an additional $246 for every 100 shares of GMCR you own. If you could collect this amount every six weeks and do not get called out of your stock, it would take about six months to make up for GMCR’s losses last week.
Imagine what someone without this knowledge is thinking…
All the pure stock owner knows as a way to reduce their basis is to buy more shares of stock. That gets even more costly. We know that we can reduce our basis by writing calls. It will reduce the basis in a bit slower manner, but at a far lower cost. One can write calls against the stock position for as many months as they can or want.
Two more thoughts before I go…
First, the situation on GMCR is an extreme example of a loss situation on a covered call, but it isn’t a total loss, nor realized just yet, as the stock is not actually sold. Let’s be grateful for the lesson now and the opportunity to work on trade management skills right away vs. seeing another winner right out of the gate and loading up on tons of stock with this strategy.
And in the coming weeks, I’ll show you even more risk management and trade management strategies to make sure your wins are big and your losses manageable.