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Covered Call Option Strategies Part 3

Covered Call Option Strategies, Part 3

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 three 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. 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.

In the prior two segments on Covered Call Strategies we discussed the basic concepts of covered calls and the analysis to perform when selecting the best options to write. This segment addresses what to do after you have written your call and you now must decide what to do to exit the position. This segment mentions rolling up and rolling down which is basically closing out the current option and writing another. There are several ways to roll up and down and they will be discussed in more detail in Covered Option Strategies Part 4.

What if the Stock Rises Above your Strike Price?

The first situation covers what to do if the price of the underlying stock rises. 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 prior analysis. Every time you enter into a covered call this is a potential outcome.

Second, if you do not want the stock to be called away 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 only reason to close out the option is if you believe that the price of the stock will continue to rise, generating a higher return that you would have realized with the covered call.

Third, you can roll up the call. Simply a roll up is where you buy back the option your originally wrote and the write another covered call. 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. As mentioned we will cover roll ups in more detail in Covered Call Option Strategies, Part 4.

What to do Nearing Expiration

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, but 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 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 Part 2 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.

Let it 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 will normally 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 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.

The criteria I like to use to let a stock be called away are:

·         Rolling forward and up significantly raises the break-even point and leaves your stock position unprotected should you experience a drop in the price of the stock.

·         Your rolling forward strategy only offers a minimal return.

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.

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.

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