One of the questions on the minds of investors who use covered calls is when to exit the position. In this segment of Covered Call Option Strategies we address what to do after you have written your call and you now must decide what to do to exit covered call position. This segment introduces what to do if the stock price rises above the strike price of the covered call, what to do as your covered call nears expiration and whether you should let your stock shares be called away.
This is part three of a multi-part series on using options to enhance the performance of your portfolio performance. In Covered Call Option Strategies, Write Calls, we introduced covered calls and described the two primary categories that are important to understand. In Part 2, we introduced the Total Return Approach to Covered Calls, as well as the risks and the potential return on investment.
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.
If your stock price rises above the strike price, you are faced with a decision. This is a positive situation as you have likely created a nice return for yourself. Generally there are three choices you available to you. 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, what if you do not want the stock to be called away, as you expect the price to rise further over time. Then as it nears expiration you should close out the position, buying the same call option. This will require you to pay the current trading price of the option plus the option commissions, reducing your total return. 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.
Third, you can buy back the covered call option and sell another one with a new date and at a higher price. This is called option rolling forward and option rolling up. Rolling an option up or forward is where you buy back the option your originally wrote and the write another covered call at a higher price and at a farther out date. 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. Covered Call Option Strategies, Rolling Options addresses roll ups in more detail.
Covered call options have a time premium that decreases in value as the option approaches the expiration date. This is the return the option creates for you. For out-of-money covered calls you need to decide whether to close out the option or let it expire. Fortunately, a straightforward analysis will help you made your decision. Basically you compare the return per day on the current covered call with the net return per day from another call. If the new call has a higher return then you should roll forward. Generally, for an in-the-money call, the best time to roll forward is when the time premium has completely disappeared from the call option. 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.
Investors can also roll down, meaning close out the current option, or let it expire and then write another, this time at a lower strike price. You might want to roll down if you expect the price of the shares to remain flat where you can write a call option at a lower strike price that would generate more cash from the time premium. In this case you have the opportunity to increase your return and lower you’re down side breakeven. Again, it is best to perform the necessary calculations as described in Total Return Approach to Covered Calls before making your decision.
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.
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:
When entering a covered call option position, 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.
The next article on Covered Call Option Strategies discusses how to roll options.
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.
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