Untitled

Covered call writing is a basic option strategy that can provide income in flat markets, income and some capital gains in up markets, and a small amount of protection of capital in down markets. Some advisors became disenchanted with covered writing during the bull market of the 1990s. Even though the strategy performed well relative to bonds, it lagged behind stock market gains. Other advisors have

Rolling Covered Calls
Covered call writing is a basic option strategy that can provide income in flat markets, income and some capital gains in up markets, and a small amount of protection of capital in down markets.

Some advisors became disenchanted with covered writing during the bull market of the 1990s. Even though the strategy performed well relative to bonds, it lagged behind stock market gains. Other advisors have recently become disenchanted because of many instances in which stock prices declined more than call premiums received, and the result was a net loss.

One potential solution to these problems is "rolling covered calls." After reviewing the basics of covered calls, I will explain "rolling" and present two examples of how it might help advisors whose stocks have performed differently than expected. For simplicity, commissions and taxes will not be included in this discussion, but these are important factors to be considered when undertaking any investment.

The Basics of Covered Calls
Covered writing involves the purchase of stock and the sale of calls on a share-for-share basis. A specific example will facilitate the discussion, so assume that today is January 5. Also assume that, today, 100 shares of Stock XYZ are purchased for $52 per share and one March 55 Call is sold for $2 per share. Graph 1 illustrates the profit and risk potential of this covered write position compared to the outright purchase of stock at $52.

The covered write position earns a profit at any stock price above $50 which is the break-even point at option expiration. The potential profit in this example is limited to $5 per share which is equal to the $3 rise in stock price from $52 to $55 plus the call premium received of $2. The up-front premium and the lower break-even point are the benefits of covered writing. The negative aspect is that profit potential is limited. Also, the covered writer bears the risk of a significant stock price decline, a situation that can result in a loss.

Chart 1

Planning Ahead
Covered writing is not simply a buy-and-hold strategy. It involves thinking ahead about appropriate action if the stock price rises or falls "too much." If the stock price rises above the strike price of the short call, then the possibility of assignment becomes more likely as expiration approaches. Equity options in the U.S. can be exercised at any time prior to expiration, and, when assignment occurs, covered writers must deliver the underlying stock.

If the stock price rises above the strike price and assignment has not yet occurred, then a covered writer faces a decision. One alternative is to simply do nothing and wait until the short call is assigned. In that event, the stock will be sold. Another alternative is to buy the short call, to close, and keep the stock. A third alternative is known as "rolling," and this will be discussed next. Finally, it is always an alternative to close the position entirely by repurchasing the call and selling the stock.

Rolling Defined
Rolling a covered call means buying, to close, an existing short call and, simultaneously, selling, to open, another call. The strike price and expiration date of the new call may be the same as or different from the call that is closed.

Rolling Up and Out
Referring back to the example above, assume that the price of XYZ stock rises to $58 and that the March 55 Call originally sold for $2 per share rises to $3 1/2. Also assume that the June 60 Call is trading for $3. A strategy known as "rolling up and out" involves buying, to close, the March 55 Call and selling, to open, the June 60 call for $3. The net cost, in this example, would be $1/2 per share, not including commissions. The result of this two-part option transaction is that the obligation to sell at $55 on or prior to March expiration has been raised to $60 on or prior to June expiration. Table 1 compares the profit potentials and break-even points of the original position and the new position, Position 2.

Table 1

The break-even price of the original position is calculated by subtracting the call premium from the stock price, or $52 minus $2, in this example. The break-even price of Position 2 is calculated by adding the net cost of rolling up and out to the original break-even price (50 + 1/2 = 50 1/2).

The original maximum profit potential is equal to the difference between the strike price of the call and the break-even price (55 - 50 = 5). The maximum profit potential of Position 2 is the difference between the new strike price and the new break-even price (60 - 50 1/2 = 9 1/2). Note also that rolling out to a June option adds approximately 90 days to the position.

Rolling Down and Out
Starting again with the original position, assume that the price of XYZ stock falls to $48 and that the March 55 Call originally sold for $2 per share falls to $1/8. Also assume that the June 50 Call is trading for $2 1/2. Given this market outcome, it would be possible to "roll down and out" by buying, to close, the March 55 Call and selling, to open, the June 50 call. The net credit, in this example, is $2 3/8 per share, not including commissions. The result of this two-part option transaction is that the obligation to sell at $55 on or prior to March expiration has been lowered to $50 on or prior to June expiration. Table 2 compares the profit potentials and break-even points of the original position and Position 3.

Table 2

The break-even price of Position 3 is calculated by subtracting the net premium received from the break-even price of the original position (50 - 2 3/8 = 47 5/8). The maximum profit potential of Position 3 is the difference between the new strike price and the new break-even price (50 - 47 5/8 = 2 3/8). Note that, in this example, rolling down and out has preserved the possibility of making a net profit even though the stock was originally purchased at $52. Depending on the size of the stock price decline, such an outcome will not always be possible.

Summary
Rolling covered calls involves buying, to close, an existing short call and, simultaneously, selling, to open, a new call. When covered calls are rolled, the new position will have a new break-even price and a new maximum profit potential. If rolling requires a net payment, then the new break-even price is calculated by adding the net amount paid to the initial break-even price. If rolling results in a net credit (amount received), then the new break-even price is calculated by subtracting the net amount received from the initial break-even price. The new maximum profit potential is calculated by subtracting the new break-even price from the new strike price. If a stock price changes more than originally predicted -- either up or down, rolling a covered call may adjust a position so that it is more in line with the current forecast.


FOR REGISTERED REPRESENTATIVES ONLY. NOT FOR CUSTOMER DISTRIBUTION.

Options are not suitable for every investor. For more information, consult your investment advisor. Prior to buying and selling options, a person must receive a copy of Characteristics and Risks of Standardized Options which is available from your broker or from The Options Clearing Corporation (OCC) by calling 1-888-OPTIONS, or by writing to OCC at One North Wacker Dr. Suite 500, Chicago, IL 60606.


TAGS: Archive News
Hide comments

Comments

  • Allowed HTML tags: <em> <strong> <blockquote> <br> <p>

Plain text

  • No HTML tags allowed.
  • Web page addresses and e-mail addresses turn into links automatically.
  • Lines and paragraphs break automatically.
Publish