This segment of covered call option strategies, rolling options discusses ways to sustain the covered call writing strategy. By their nature options are short term investments tools. Due to their low price, it is easy and inexpensive to close out one option position and they establish another with new terms. This is called rolling your options.

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

Rolling Covered Call Options

The Chicago Board Options Exchange (CBOE) defines rolling covered call options 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 call 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.

This strategy takes advantage of the decay of the time premium of an option. 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 depicting 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 90 day time period and then accelerates further with 30 days to go. Rolling options takes advantage of this important fact.

Rolling Forward Covered Calls

Rolling your covered call option forward 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.

The decision 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 do 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, if possible. This allows me to take advantage of the more rapid decay of the time value premium. As mentioned in the Total Return Approach, 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 Covered Calls

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 fallen causing the current call option to be relatively worthless and one with a lower strike price to be a better choice.  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, to help offset some of your loss in anticipation of a recovery of the underlying stock.

When rolling down you buy back the existing call, most likely at a profit, since the underlying stock price declined. Then the investor writes another covered call at a lower strike price. The investor could also write the new covered call at a date further into the future.

An example will help to demonstrate the advantages of a roll down. The stock of ABC is trading at 24 and an investor is writing (selling) a June 25 covered call for $2.50. It has 50 days to expiration. This means the time premium on the June 25 covered call is $2.50 and it will reach zero, if the share price remains at or below 25 when the option expires in 50 days. Over the next 20 days the price of ABC falls from 24 to 22. As a result the price of the June 25 covered call falls from $2.50 to $0.50. This give the investor a $2.00 profit for each share owned on the covered call, which helps to offset the loss of $2.00 in the stock price. If the investor held the June 25 covered call until expiration, another 30 days, the maximum additional profit available on the covered call is $0.50 per share. In the mean time, the June 22.5 covered call is selling at $1.50. The investor could buy back the June 25 covered call at $0.50 and sell the June 22.5 covered call for $1.50. This transaction lowers the break even of the underlying stock by $1.00 ($1.50 - $0.50). It also offers the investor increased profit from the covered calls of $1.00, as long as the price of ABC stays at or below 22.50. If the price of ABC stays below 22.50 over the next 30 days, then the roll down strategy generates a total profit of $3.50 ($2.00 from the June 25 write and $1.50 on the June 22.5 write).

What happens if the price of ABC rises to 23 over the next 30 days, above the strike price of the June 22.5 wrote. In this case the price of the June 22.5 covered call would have an intrinsic value of $0.50. The time premium would decline to near zero as the expiration date approached. In this case the investor would need to buy back the June 22.5 covered call before the option expires, to avoid having the shares assigned.

One of the best ways to understand the implications of rolling down is shown in the chart below. The original covered call was a June 25. However, the price of ABC stock fell, generating a gain from the June 25 covered call write. At this time the investor closed out the June 25 write at a profit, since the price to buy the call was lower. Then the investor wrote another covered call at a lower strike price of 22.5. This roll down creates new profit potential at the lower share price as shown the chart. The lower covered call write provides more down side protection. The decision on whether to roll down depends on your expectations for the stock price as it nears the expiration date.

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 Covered Calls

When the price of the underlying shares rise above the strike price, the investor is faced with two alternatives. 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 might 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 could be raising your breakeven point, if you are buying back the current covered call at a loss. 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 sooner than expected. Most stock prices rise and fall even when they are trending up. A good “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 your 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 with the new covered call. 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 have three alternatives. First, you can let the stock be called away. the risk you take is the stock price could continue to rise further. 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.

Second, you could elect to write the covered calls at interim highs as determined by technical analysis of the charts. This way you take advantage of the higher premium that is available as a stock reaches an interim high. The profit is made when the stock then pulls back during a period of profit taking. This strategy takes advantage of the long term up trend in the stock and the interim pull backs that often take place.

Third, the investor could consider using trailing stops to protect against a drop in the stock price below a predetermined support level. This frees the investor from the negative aspects of the prior 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 learning to use covered calls can help to lower your downside risk, increase the returns on your portfolio and beat the market. 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.

If you want to learn more about using options consider reading Options Made Easy: Your Guide to Profitable Trading (2nd Edition) by Guy Cohen. It is a good way to help you to get started learning how to use put options to reduce your down side risk.

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