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 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.
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.
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.
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.
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.
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