Sunday, February 5, 2012

Rolling-Up A Covered Call

A point of resistance to participating in covered-calls for many traders is the perception that once the price rises above the strike price you forego all further opportunity for profit. In my experience, for most equities, this is not true. First of all, one can always roll the call. Rolling is an operation whereby a trader buys back a soon-to-be-expiring call and sells an option at the same strike with more time-to-expiration. This is a standard operation and many brokerages, including ThinkOrSwim, can execute rolls in a single trade and usually for a credit on short-option rolls.

Where does that leave you? After rolling a covered-call, one is left with an in-the-money, short-option. This doesn't look good the first time you see it because it may have a small extrinsic value but here's a few points to be mindful of:
  1. Higher potential gain. If you rolled for a credit then the new short-option will have its entry-price set up higher than the first initiating call you sold and this represents higher potential profit. Buy-back that rolled option for cents on the dollar and you definitely win.
  2. Higher delta. Presumably one initiated the covered call out-of-the money which is always less than 50 delta. If you rolled an in-the-money call then the delta of the new short-option will be somewhere north of 50. Now, if the equity starts to slide then the gain in the new covered-call accumulates more rapidly than it would have in the originating call.
  3. Direction rarely holds for very long. Most stocks zig-zag their way up due to profit taking.
  4. You have all the time in the world. The shares you purchased don't expire so you can keep rolling the calls almost indefinitely.
These circumstances lead to opportunities to advance the strike price of a covered-call for little cost or even a credit. What one is looking for is a pullback after rolling the ITM call and preferably near the expiration of the new call. This pullback will produce a fat gain in the ITM call but your budget for rolling-up is the total of the accumulated roll-credits.

What we are looking to do is what is called a diagonal roll. We are seeking to roll our ITM call up in strike price and out in time. We are seeking to roll the call diagonally up for something like the accumulated roll-credits. If this up-diagonal prices, net of accumulated roll credits, for a credit or even a small debit (like a typical roll-value if you want to forward-invest the next roll credit, say) then it is worth the doing, because you lock-in the price differential of the strike prices in the underlying equity. Keep in mind that rolling diagonally down is almost always a steep credit and thus, easy. In this manner, given sufficient patience, it is almost always possible to advance the strike price of a covered call. Thus, there is a pathway to make money with covered-calls on the way up as well as down ... provided, of course, that the options of the underlying equity are relatively liquid.

Illiquidity is the gotcha to any option strategy. So be sure to choose an equity with liquid options - look at the front-month at-the-money options. The bid-ask spread should be no more than 10-20 cents. In the front-month there should be thousands of contracts of open-interest and triple digit open-interest in the ATM strikes. If not, then maybe don't trade the options. It hasn't always stopped me from selling covered-calls but I'm more willing to let the shares go if they go in-the-money.

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