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Covered Call Option Expiration

One of the questions on the minds of investors who use covered calls is what should they do when the expiration date of the covered call approaches. In some cases you might experience a rise in the stock price above the strike price of the covered call. Now you now must decide to either let your shares be called or buy back you covered call option before it expires. On the other hand, if your strike price remains above the price of your shares, you are facing another decision before your covered call reaches expiration.

What if the Stock is Above your Strike Price, or In-the-Money?

As your covered call nears expiration, your stock price rises above the strike price. This is commonly referred to as an in-the-money option. In this case it is a positive situation, as you have likely created a nice return for yourself through the appreciation in the price of your stock. You will have to decide what to do about your in-the-money covered call option as it approaches expiration. Generally, there are three choices you available to you when your covered call nears expiration.

First, you can do nothing and let the stock be assigned. In this case you will generate the maximum expected return you identified in your analysis as discussed in the Total Return Approach to Covered Calls. Every time you enter into a covered call this is a potential outcome.

Second, maybe you do not want the stock to be called away, as you expect the price of the stock to continue to rise. When the covered call nears expiration, you should close out the position, buying back the same call option. As the price of the underlying stock rises, so to will the price of your covered call, though not as much. Since the time premium of your covered call falls, it helps to lower the value of the call as it approaches the expiration date. It is this time premium that keeps the value of the covered call option above the value based on the stock price alone.

When you buy back the covered call, you will pay the current trading price of the option plus the option commissions, reducing your total return. However, you are benefiting from the higher price of your share price, which more than offsets the cost to buy back the covered call.

The primary reason to close out the option is you believe that the price of the stock will continue to rise, generating a higher return than you would have realized with the covered call. Or you might want to delay taking your capital gain for a number of reasons including delaying realization of capital gains.

The third reason to buy back a covered call as it approaches expiration, is to roll forward to a new covered call option. Rolling an option up or forward is where you buy back the option your originally wrote and write another covered call at a higher price and at a new date further away. There are several strategies available to you when you want to roll up your covered call option position. Some are good and some can get you into trouble. Rolling Covered Call Options addresses rolling up an option in more detail.

What do do if the Stock price is below the Strike Price

For covered calls whose strike price is above the stock price (known as out-of-money covered calls), you need to decide whether to close out the option and roll it forward or let it expire. If you let the out-of-the-money covered call expire, you will receive the time premium. In this case you do not have to do anything since the covered call expires automatically on the third Saturday of the month.

Fortunately, a straightforward analysis will help you made your decision on whether to let the covered call option expire or roll it forward. You compare the return per day on the current covered call with the net return per day from another call with a date farther in the future. If the new call has a higher return then you should roll forward. For an out-of-the-money call, the best time to move into another call option is when the return offered by the near term option is less than the return offered by the longer term call.

The Total Return Approach to Covered Calls provides an description on how to make the decision to let the covered call option expire or roll it forward.

There is a margin issue that the covered call option writer must be aware that applies on the expiration date. If you wait for the option to expire worthless that day and you write another option to cover yourself going forward on expiration day, you will be writing an uncovered option. Options actually expire on Saturday. If you write a call option before the prior covered call option expires, you must provide the necessary security to cover the margin call. Most investors who are writing covered calls do not intend to write uncovered calls. In this case, it is best to either close out the option before it expires worthless or wait until the following Monday and then write another covered call, after the option has expired.

Should You let your Covered Call be Called Away?

When writing covered calls, the option writer must always be prepared to decide whether to let the stock be called away as it approaches the expiration date. Your stock is likely to be called away (assigned) when the time premium disappears with the stock trading at or above the strike price. The time premium normally disappears just before the option expires. Options traded on exchanges in the United States can be called at any time. European options and options traded on many other countries can only be called on the last day of the option, the day it expires.

If you like the stock and believe it is one of the best ones to hold for your total return approach to covered call writing, then you may want to buy back the option before the stock is called away. This way you can write another covered call on the stock providing additional down side risk and improving the return in your portfolio.

Normally, it is advantageous to roll forward when the total return of the stock and the covered call is meeting your objectives. Keep in mind that you need to include commissions and fees for buying and selling your stock as well. If you decide the return is less than acceptable and you can get a better return with another stock for your covered call writing strategy, then you should let your stock be called away.

If both of the following criteria are met, then it is best to let the stock be called away:

The Bottom Line on Covered Call Expiration

As the expiration date of a covered call option nears, an investor should have an exit strategy in mind. In fact, investors should have several exit strategies at hand, depending on the price movement of the underlying stock. 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.  The decision when to exit the covered call option should be based on analysis of the total return for the position vs. the return of entering a new covered call position using the Total Return Approach to Covered Calls.

To learn more about covered call option strategies, I suggest reading how to Writing Covered Calls. Rolling Covered Call Options discusses how to roll your covered call options as they approach their expiration date.

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 call options.