Options Lesson 2: Rolling Covered Calls

Rolling Covered Calls SPONSORED BY

Greetings, Fools! Today we're going to build on your knowledge of writing covered calls with a little something called follow-up action. As you know, when you write covered calls, you need to be ready to have your stock sold away at your call's strike price. However, you always have the choice of adjusting your trade before that happens. In cases where the stock moves sharply, or when you've earned most of what you can from your call options, you can roll your calls up, down, and/or out, modifying your strategy to your benefit. Let's start with one of the most common moves: rolling up and out. Rolling Up and Out to Gain More Upside When you write covered calls on a stock, only to see the shares lift off through your strike price and keep ascending, you're leaving potential profits on the table. It may be time to follow up by bringing out the "roll up and out" trade. To do this, you "buy to close" your original covered calls and then "sell to open" new covered calls at a higher strike price (that's the roll up), usually with a later expiration date (the roll out). This strategy provides you with additional upside in the stock before it's potentially called away. It can also be a useful tactic if you're concerned about losing shares of a strong dividend-paying stock. For example, assume you bought a stock at $12 and wrote $15 covered calls that paid you $1.50, for a potential net sell price of $16.50; today the shares are $17, and you think they'll go higher. Your adrenaline is pumping, but being a Fool, you decide to rationally and calmly roll up and out to a higher strike price to gain more upside. Here are the numbers: Math of Rolling Up and Out (Stock Bought at $12, Now at $17) Payment for writing $15 calls expiring in six months from start $1.50 Cost to "buy to close" $15 calls now expiring within days ($2.10) Net cost to close $15 calls ($0.60) Payment for writing $17.50 calls expiring three months later $1.20 Total credit for rolling up $0.60 New net sell price $18.10 Benefit of rolling up 9.7% additional upside In this scenario, you're able to roll your covered calls up to a higher strike price, and out to a later expiration date, earning a 10% higher net sell price on the stock and still maintaining a credit on your covered calls (meaning you were paid overall to write them). In some cases, you'll need to pay to roll up your covered calls (a net debit) because the net cost of closing your original calls exceeds the amount that writing new calls will pay you. To minimize or eliminate this, you roll your options out to even later expiration months that pay more. Additionally, when rolling up and out, you usually close your original calls only when they have little time value remaining -- in other words, once they're near expiration, or when they're so deep in-the-money (meaning the stock is far above the strike price) that the options have little time value even if expiration is months away. An option's time value (the value it holds above its true value to account for possible changes in the underlying stock price before expiration) will begin to disappear more steadily once expiration is 90 days away, as long as overall volatility is not increasing. At 60 days, this decay speeds up, but only at 30 days will time value really begin to evaporate quickly and, finally, almost disappear (some time value will remain right up to the last day). Thus, it's usually during the expiration month (or even week) that you'll close your original calls to roll them out. Writing new covered calls that expire in 90 days or more will reward you with ample time value again, while you want to pay little time value to close your old calls (in our example, a $15 call asking $2.10 on a $17 stock only has $0.10 in time value). So, roll up and out when: You see more upside in the stock, want to keep dividend payments, or aren't ready to sell after all. You believe the stock won't decline much (not more than 10% or so). The extra profit potential of rolling up is worth the cost (with a debit roll-up) and is worth the extra risk of continuing to hold the stock. Rolling Up But Not Out Sometimes, when a stock gains ground, you may want to roll your covered calls up, but not out -- capturing some of that upside even if it means you incur a net debit. Perhaps you're feeling bullish and think the stock will keep climbing. By just rolling up, you can make a quick correction to your trade. In this case, you "buy to close" your original covered calls and write new ones at a higher strike price but the same expiration month. Since the options expire simultaneously, you don't need to worry about time-value dissipation before making the trade. Simply adjust your position, and if the stock goes higher, you'll end with a larger gain than if you hadn't rolled up. Rolling Down to Reduce Risk On the other hand, when a stock declines, you may want to roll down your covered calls to earn another option payment and marginally decrease your risk. As shares fall in price, your original covered calls offer you less additional income and become a less effective hedge. Booking your profit and rolling down to a lower strike price -- usually, but not always, with the same expiration -- will increase your option income. Be warned that rolling down lowers your overall profit potential on a stock sale and should only be considered if you no longer believe shares will appreciate in value anytime soon. Rolling down when a stock is bruised means that you're accepting a more modest payment for a lower strike price, so it's not an ideal situation -- only consider it when you want to be especially defensive. Finally, make sure it's not a better idea just to sell the underlying position rather than writing new calls. Rolling Out to Move On If you've earned most of what an option-writing trade can pay you (as a general rule, we say 85% or more), start to consider taking the risk off the table by closing it early. When covered calls reach this point, you have little left to earn but are still completely capping your upside by keeping the position open -- so the risk/reward trade-off is unfavorable. If you want to keep the stock covered, consider closing your calls and writing new ones for a later month and higher payment. If you no longer want to cover your shares, simply close your calls for most of the gain and uncap your potential profit on the stock. Bottom Line on Rolling Covered Calls Not all covered calls should be rolled up, down, or out when a stock moves. If rolling your options only pays a little extra, greatly increases your break-even price on the stock (because closing your calls results in a net debit), leaves you with little downside protection, or lowers your sell price too far (when rolling down), then the strategy should be shelved. That's not a bad thing: Covered calls encourage disciplined investing. Rather than chasing a stock, the strategy makes you stick to your thesis and anticipated sell price. Too often, investors chase stocks higher only to regret paying to roll up when the stocks fall back. In many cases, letting some calls be exercised and taking some profits following a strong move is ultimately the better alternative. "Rolling Covered Calls" is brought to you by the Motley Fool Options team.

This is a promotional message from 2000 Duke Street, Alexandria, VA 22314 You may choose to subscribe, unsubscribe, change format or opt-out of further promotional mailings. The Motley Fool is not registered as an investment advisor and does not provide individualized advice. Copyright © 1995-2011 The Motley Fool. All rights reserved.