Rolling a Covered Call
Imagine you’re running a 30-day covered call on stock XYZ with a strike price of $90. That means you own 100 shares of XYZ stock, and you’ve sold one 90-strike call a month from expiration. When you sold the call, the stock price was $87.50, and you received a premium of $1.30, or $130 total, since one contract equals 100 shares. Now, with expiration fast approaching, the stock has gone up to $92. In all probability you will be assigned and have to sell the stock at $90.
The only way to avoid assignment for sure is to buy back the 90-strike call before it is assigned, and cancel your obligation. However, the 90-strike call is now trading for $2.10, so it will hurt a bit to buy it back. To help offset the cost of buying back the call, you’re going to “roll up and out.”
That means you want to go “up” in strike price and “out” in time. The idea is to balance the decrease in premium for selling a higher OTM strike price versus the greater premium you’ll receive for selling an option that is further from expiration (and thus has more “time value”).
Here’s an example of how that might work.
Using your broker's spread order screen, you enter a buy-to-close order for the front-month 90-strikecall. In the same trade, you sell to open an OTM 95-strike call (rolling up) that’s 60 days from expiration (rolling out). Due to higher time value, the back-month 95-strike call will be trading for$2.30. Since you’re paying $2.10 to buy back the front-month call and receiving $2.30 for the back-month call, this trade can be accomplished for a net credit of $0.20 ($2.30 sale price - $2.10purchase price) or $20 total.
Let’s look at all the good news and bad news surrounding this trade. As you’ll see, it’s a double-edged sword.
Since you’ve raised the strike price to $95, you have more profit potential on the stock. The obligation to sell was at $90, but now it’s at $95. The bad news is, you had to buy back the front-month call for 80 cents more than you received when selling it ($2.10 paid to close - $1.30 received to open). On the other hand, you’ve more than covered the cost of buying it back by selling the back-month 95-strike call for more premium. So that’s good.
But you have to consider the fact that there are still 60 days before the new options expire, and you don’t really know what will happen with the stock during that time. You’ll just have to keep your fingers crossed.
If the back-month 95-strike short call expires worthless in 60 days, you wind up with a $1.50 net credit. Here’s the math: You lost a total of $0.80 after buying back the 90-strike front-month call. However, you received a premium of $2.30 for the 95-strike call, so you netted $1.50 ($2.30 back-month premium - $0.80 front-month loss) or $150 total. That’s not a bad outcome (see Ex.1).
However, if the market makes a big move upward in the next 60 days, you might be tempted to rollup and out again. But beware.
Every time you roll up and out, you may be taking a loss on the front-month call. Furthermore, you still have not secured any gains on the back-month call or on the stock appreciation, because the market still has time to move against you. And that means you could wind up compounding your losses. So come to think of it, rolling’s not really a double-edged sword. It’s more like a quadruple-edged shaving razor.
