Beat The Market By Using Call Covered Traded Options Strategies - Part 4

By: Hans_Wagner

Investors who wish to beat the market using a conservative approach might want to consider using covered call option strategies to enhance their overall return. Writing covered calls helps to improve the total return of an investor's portfolio if they apply several important principles. Covered calls are approved for use in Individual Retirement Accounts as they are considered a conservative way to use options by the authorities. This is part four of a multi-part series on using options to enhance the performance of your portfolio performance. In Part 1 , we introduced covered calls and described the two primary categories that are important to understand. In Part 2 we introduced the Total Return Approach, as well as the risks, the potential return on investment and what strategy to use given your assessment of the situation. Part 3 we discussed some of the basic strategies to exit the position.

There are several good books on options such as Options Made Easy: Your Guide to Profitable Trading (2nd Edition) by Guy Cohen. It is an easy read that will help you understand options. Another excellent source is Options as a Strategic Investment by Lawrence G. McMillan

Part 4 introduces some of the ways to roll forward, roll up or roll down your covered call positions.

Rolling Options

The Chicago Board Options Exchange (CBOE) defines rolling as “ A follow-up action in which the strategist closes options currently in the position and opens other options with different terms, on the same underlying stock.” For the covered call writer rolling or “the roll” is a strategy used by investors who wish to keep the underlying asset and generate additional income from writing new options as the older options have either expired or have been closed out. This rolling action requires the investor to write a call with a different strike price or different expiration date, or both. Basically covered call writers can roll their position forward, roll their position down or roll their position up depending on the current value of the underlying asset.

The time premium of an option accelerates its decay as it gets closer to the expiration date. The chart below from trading-plan.com is one of the best I have seen describing the time premium decay process. This time decay is key element of the covered call writer's strategy. Notice that the option starts to decay more rapidly at about the 60 day time period and then accelerates further with 30 days to go. Rolling options takes advantage of this important fact.

Rolling Forward

Rolling forward your covered call option requires you to buy back the current covered call and sell another covered call with a new expiration date that is further out with the same strike price. Rolling forward takes advantage of the larger time value premium that is available in an option with an expiration date further out than an option that is about to expire in the near future.

When deciding when to roll forward starts with whether you have an in-the-money or an out-of-the-money call option. The best time to roll forward an in-the-money option is when the time value premium has completely disappeared. There is little risk your call will be assigned as long as there is some time premium remaining in the option. When the option gets close to, at or trades at a discount to parity, there is a good chance arbitrageurs will call your shares. Therefore, if you wish to keep your shares it is necessary to buy back the in-the-money call option before this happens. The best time to d this is just before the time premium goes to zero, which normally occurs near or at the expiration date. At this time the in-the-money writer can roll forward their position buying back the current covered call and then writing another call with an expiration date further out. I usually look to roll forward to the option that expires two months out. This allows me to take advantage of the more rapid decay of the time value premium. As mentioned in Part 2 it is important to do your analysis of the expected returns before making a final decision.

Out-of-the-money options also experience decay of the time value premium and reach zero as the expiration date arrives. However, at some point in time the relatively small size of the remaining premium of the daily return of the existing call option will eventually be lower than what you might be able to receive from an out-of-the-money call option with a longer expiration date. The best way to make this decision is to calculate the return per day from the current call option and compare it to the return per day from a longer term call. When the longer term call has a higher return per day, you should roll forward.

The table below shows this calculation for Apple Corporation. This investor currently has written a covered APV LS (December 2007 195 call option). This option expires in 15 days and has a time premium of $565.00. You should add any dividend you expect to receive during the time period of the option and subtract the commission and fees to buy back the written call to determine the true remaining value left in the option. Dividing this number by 15 gives you the expected return per day. Comparing this return to APV AS (January 2008 195 call option) daily return allows you to make a more informed decision when to close out the current option and write another one. Make the trade when the return on the future option is greater than the current one.

It is always best to compare several alternatives when you are deciding to roll forward including three or more expiration months. In addition it is usually helpful to look at the underlying stock's fundamental and technical situation to help decide if this stock is the right one to continue your roll forward strategy and where the likely support and resistance levels are. 

Rolling down

Rolling down is when an investor with a covered call decides to close out the current call and write another one with a lower strike price. This occurs after the price of the underlying stock has encountered a sizeable drop. In most cases investors should avoid being in this position since covered calls only provide a relatively small amount of down side protection. Instead you should either sell the stock when it reaches a pre-determined stop or use some other hedge such as a protective put. However, if you find that the price of your stock has fallen you can then initiate a strategy of rolling down your covered calls.

When rolling down you buy back the existing call, most likely at a profit since the underlying stock price declined and then write another covered call with a lower strike price. One of the best ways to understand the implications of rolling down is shown in the table and chart below. The original covered call was a June 25. However, the price of ABC stock fell negating the profit potential from the June 25 write. At this time is would be prudent to close out the June 25 write at a profit since the price to buy the call would be lower since the price of ABC fell. Then write another covered call at a lower strike price such as 22.5, as shown in the table. This roll down creates new profit potential at the lower share price as shown in the table and the accompanying chart. This roll down generates a lower overall profit potential than the original June 25 write. However, the profit from the June 25 write at a stock price of 24 or lower will be less than the profit from the June 22.5 write. The lower write provides better down side protection. As a result the decision on whether to roll down depends on your expectations for the stock price. 

Deciding when to roll down is often made by investors who use technical support and resistance analysis. Knowing the technical levels of a stock helps to determine if it is worth the risk to roll down vs. the expected result of remaining in the current covered call.

There are several other rolling down strategies including how to address a locked-in-loss and rolling down part of a position rather than all it. If you have a locked-in-loss, no matter what call option you write you can either sell the stock and move on or look to writing a series of covered calls to help offset the current loss with the expectation the price of the shares will rise over time. Writing covered calls when you have a locked-in-loss will also help to lower your break-even point. If you are able to write a covered call and then roll forward several times you might be able to turn your loss into a profit, especially if the price of the shares either remains the same or rises. Keep in mind that should the price of the underlying shares rise significantly, you may be faced with a situation where your covered call locks you into a loss even when the shares are not higher than when you purchased them.

This is where rolling down part of the position might prove useful. Writing a new rolled-down covered call for a portion of the shares allows the remaining shares to appreciate without being locked into a loosing position. The shares not covered by the covered call that was rolled down are not limited in their appreciation by the covered call. However, you also do not have as much downside protection. The decision to use a partial roll down is highly dependent on your expectations of the underlying stock to rebound.

Rolling Up

When the price of the underlying shares rises and is above the strike price the investor is faced with two alternatives. Just remember you have a profitable position which is good, no matter which strategy you take. Your first alternative is to let the shares be called away. With this alternative you achieve the return you expected when you analyzed the trade. On the other hand you can close out the original covered call and write another at a higher strike price. This is called rolling up.

The decision to let you shares be called away depends on your assessment of the underlying security and how it fits your Total Return Approach. If the stock is a good fit for your future strategy, that is it has the potential to continue to deliver nice total returns that include stock appreciation and income from writing covered calls, then it is prudent to close out the covered call and then roll up. If, in your opinion the stock is no longer well suited for a total return, then it is prudent to let the stock be called away, using the proceeds to establish a more favorable total return covered call writing strategy.

While rolling up has its appeal, it also has some issues that investors must be aware. When you roll up to a higher strike price you are raising your breakeven point. This isn't a problem as long as the stock increases in price. However, should it decline then you will be faced with a loss position much sooner than expected. Most stock prices rise and fall even when they are trending up. A common “rule-of-thumb” is to avoid rolling up if you are unable to weather a 10% drop in the underlying security.

There is another problem with rolling up that you should understand. Let's say you are holding a stock with no intention of letting it be called away and it rises up to and past the strike price fairly quickly. As a result you buy back you covered call incurring a loss on the transaction. Then the stock continues to rise and you buy back the next covered call again incurring another loss. This action is negating all the benefits from writing covered call in the first place. If you find yourself in this position, then the best action is to change your strategy. You can either let the stock be called away or consider using trailing stops to protect you on the down side and free you from the negative aspects of the prior covered calls. If the stock is called away you can establish another position in either the same stock or perhaps one that is more suitable to your total return approach to covered calls. The trailing stop will protect you should the stock reverse its trend and go down by more that the stop.

The Bottom Line

Investors who expect to successfully employ a total return approach to writing covered calls must be prepared to address the various outcomes they will face after entering into the call option contract. A call option loses its time value as it nears expiration which is one of the reasons investors use covered calls. Whether the stock rises, stays flat or falls, the covered call option writer must decide what to do as the option nears the expiration date. The basis for this decision is the expected return you will receive from your analysis of the various option strategies that are available. You should consider whether the current underlying stock is the best one for your covered writing strategy or if you should move on to another one. As such investors should consider blending the various rolling strategies to find the best one that meets their objectives and risk levels. 

In any case using covered calls can help to lower your downside risk and increase the returns on your portfolio. All it takes is doing some homework by examining the various strategies that are available to you and then making the commitment to execute your preferred strategy.

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

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