Covered call options are often pitched as a low-risk way to generate an income on a long-term stock position. While you boost income with a covered call, there can be a high opportunity cost if the underlying stock moves sharply higher and you’re forced to sell early. Rolling a covered call is a common way to manage these losses, but this strategy involves another set of risk factors that investors should carefully consider.
Let’s take a look at how covered calls can go wrong, how rolls can help mitigate losses, and when to use rolls.
When Covered Calls Go “Wrong”
The covered call strategy involves writing a call option on an underlying stock position that you already own to generate an income. For example, you may own 100 shares of Orange Inc. at $175.00 for a total of $17,500.00 and sell an out-of-the-money call option with a strike price of $177.00 for $3.00 a piece or $300.00 in total premiums. If the stock remains below $177.00, you receive a $300.00 virtual dividend (a roughly 20 percent annualized rate!).
The risk of a covered call is that the option ends up being exercised. Orange Inc. could rally to $200.00 per share and you would be forced to sell the stock at $177.00. While you haven’t necessarily lost any money, there is a high opportunity cost of $2,300.00. You could buy back the call option to avoid selling stock – thus avoiding potential tax implications – but it would cost more to buy back the option than you gained from the premium.
Even if the stock doesn’t rally sharply higher, you may be faced with a situation where the stock is trading uncomfortably close to the exercise price. You may want to avoid the risk of the option being assigned and decide to buy back the option to be on the safe side.
Rollovers to the Rescue
The good news is that you can offset the cost of buying back the call option by rolling over the options. When you roll an option, you are funding the repurchase of your original call with the sale of a new option with an expiration in the future. The goal is to mitigate any losses in the near-term and maintain the ability to make the position profitable over time.
There are several ways to roll over an option:
- Roll Up – Moving the strike price higher.
- Roll Down – Moving the strike price lower.
- Roll Out – Moving the expiration date further into the future.
For example, you could roll the aforementioned Orange Inc. covered call position by entering a buy-to-close order for the front-month $177.00 strike call option and simultaneously sell-to-open an out-of-the-money $220.00 (roll up) call option that’s 60 days from expiration (roll out). You might pay money to buy back the front-month call option, but you will receive money for the back-month call option, which could result in a net credit or much less of a debit.
If you’re just worried about assignment, you may decide to just roll out the option without moving up the strike price. This often enables you to realize a net credit since the time value on the option with a later expiration date is typically higher than the time value on a nearer option. This is particularly true for options that are very close-to-the-money since they have the highest amount of time value already built in to the price.
Benefits & Drawbacks
The benefits of rolling a covered call option should be obvious: You avoid assignment and offset the costs associated with buying back the front-month call option. But, rolls can be a double-edged sword. The greater time until expiration (or time value) for the new option position means that you have a greater risk of another assignment if the underlying stock continues to rally higher over the ensuing expiration period.
Of course, you may be tempted to simply roll the option again if this happens, but it’s important to recognize that you’re taking a loss on the front-month call option each time. You aren’t locking in any realized gains with each roll and you’re also missing out on the stock’s appreciation over time. Even worse, you’re losing money to commissions with each trade since you’re closing one position and opening a new position.
When to Roll an Option
The decision of whether or not to roll over a covered call option depends largely on your expectation surrounding the underlying stock. If the rally turns out to be long-term, the best decision would be to realize the loss on the covered call. If the rally is short-term, a roll might be a good way to avoid realizing losses on the covered call position. One facet to keep in mind: No one can consistently predict future stock prices, so it is best to apply a consistent, systematic approach to your stock and option trades.
Suppose that Orange Inc. reported a strong quarter of revenue growth and analysts have expressed confidence in the future. In this case, you might assume that the stock will continue to rally beyond $200.00 and it might make sense to buy-to-close and take a loss on the covered call option. You can then establish a more conservative covered call strategy for the following month and start over in building option income over time.
On the other hand, Orange Inc. may have soared to $200.00 due to rumors of a buyout that never materialized, and the company’s management has laid the rumors to rest. You might assume that the stock will fall back to its previous levels as the rumor-driven rally fades and the future will be a lot more predictable. In this case, you might want to consider rolling over the position since there’s a better chance that you could avoid those losses.
The Bottom Line
Rolling a covered call position is a great way to avoid selling your shares, but the strategy is a double-edged sword. In general, you should consider rolling a covered call if you think that the underlying stock’s move higher was temporary. Otherwise, you might be a lot better off simply taking the loss on the covered call and then starting over fresh during the next month where you can be more conservative with the option dynamics.
Snider Advisors’ covered call strategies are designed to help investors generate an income from their portfolios. By carefully analyzing opportunities, we help you identify high probability trades and maximize the cash flow from your stock portfolio. Sign-up today to learn more about our approach to covered call options.