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Rolling Out And Up To Capture Share Appreciation: A Good Idea?

Covered call writing has some drawbacks as do all investment strategies. Profit limitation by the strike price is one such disadvantage. How do we manage a situation where the price of the stock moves well above the strike sold? Some covered call writers will roll out and up (to a higher strike price and a later date) in an effort to capture the share appreciation previously limited by the original option sold. This is very different from rolling out and up to continue to capture option profit perhaps in addition to some share appreciation. In this article, I will use Facebook, a stock recently on our Premium Stock List to evaluate if this is a good idea. Keep in mind that I( am alluding to a strategy where the goal is to capture share appreciation when a stock price moves well above the original strike sold, not option profit.

In early December, FB moved above its 20-d exponential moving average and seemed like a great candidate for covered call writing. Let’s look at a chart depicting when this bullish event took place:

covered call writing and technical analysis

FB moves above it’s short-term moving average

 

At the time a near-the-money strike could have been sold for a 4%, 1-month return. The price 0f the stock continued to increase and near expiration FB was trading @ $54.69, leaving the $50 call $4.69 in-the-money. In an effort to capture the $4.69, some investors look to roll out and up to a strike above $54.69. Let’s have a look at an options chain showing the cost to close our short $50 strike position:

Rolling options strategies

Facebook options chain

 

The cost to close is $4.80 and that will allow our shares to now be worth current market value since there is no longer an options obligation. Next, as the proposed strategy goes, we must sell another option to negate the $4.80 cost-to-close. Let’s check the January options chain for the $55 call for FB:

Covered call writing rolling strategies

Facebook: January options chain

 

Rolling out and up to the January $55 call will result in an options debit of $2.39 ($4.80 – $2.41). Investors may then attempt to roll out more months so that the time value will compensate them for the cost to close the original option. Here are the stats for other $55 calls:

  • February: $4.40
  • March: $5.00
  • June: $6.90

To get fully compensated for the cost to close we would have to roll out and up to the March $55 call and there the option credit would be minimal, almost a wash. It will also limit our upside over the next 3 months to $0.31 ($54.69 to $55).

If we rolled out and up to the $60 call to give additional opportunity for more share appreciation, here are the stats:

  • January: $0.86
  • February: $2.60
  • March: $3.15
  • June: $5.00

In this scenario, we would have to commit to June to make up for the cost-to-close and like the March $55 call, it would almost be a wash.

Why this is not a good idea

I don’t like this idea because we are changing our goals.  Originally, we wanted to generate monthly cash flow by selling stock options. Our training has taught us that one of the risks with this strategy is profit limitation by the strike price. This is the obligation we undertook when we sold the option and the reason the option holder paid us all that cash. In this scenario, we were successful in maximizing our 1-month option goal and we must accept (although we can still manage this position) the limitations of the strategy. By rolling out farther and farther from the current month we are obligated to hold the stock through earnings reports, a gigantic drawback. In addition, we are undertaking a longer-term obligation when we may not want to own the underlying security in the future.

What then can we do?

We are in the driver’s seat, having maxed our 1-month position:

1- Wait for expiration Friday to see if a rolling strategy makes sense from an options perspective. It could mean rolling out or rolling out and up but not to capture share appreciation only.

2- If the strike is deep-in-the-money mid-contract, look to close the entire position if the time value approaches zero and use the cash from the stock sale to start a new covered call position and a 2nd income stream. This is the mid-contract unwind exit strategy I detail in my books and DVD Programs.

3- Take no action and allow assignment where your shares are sold at the strike price. Perhaps the calculations from an options perspective do not meet your goals or maybe there is an earnings report due out the next month.

4- Set up two separate accounts. One for covered call writing and one for stock buying and selling only. This will allow you to make the best decisions for each strategy and not have different goals cloud our investment decisions.

Conclusion

Covered call writing is a strategy that generates monthly cash flow by selling stock options. The main drawback is that share appreciation is limited by the strike price. We cannot eliminate this disadvantage, just manage it. It is critical to avoid poor investment decisions by using one strategy with a defined goal and trying to also gain the benefit of another strategy with different goals. Don’t get greedy!

New live event just added:

This past week I accepted an invitation to participate in an E-Money Show event. This is a live webcast on Tuesday March 25th from 3:20 -4:20 ET. In addition to a review of the basics of covered call writing I will also analyze a trade I recently made using some of the BCI principles. Admission is free but you will be required to register with The Money Show (also free) if you are not already a member. I will post the link to register on this site once it is provided to me.

 

Next live seminar:

World Money Show, Orlando, Florida:

 

Market tone:

The markets declined this holiday-shortened week due to some earnings disappointments, concerns about emerging markets, slower growth in China and lower Federal Reserve stimulus. That said, there were signs of economic improvement with this week’s economic reports:

  • The Conference Board’s index of leading economic indicators (a composite index of ten economic indicators that typically lead overall economic activity. The index includes indicators such as housing permits, new orders for consumer goods, consumer expectations, and performance of the S&P 500 Index) increased by 0.1% in December, for the 6th straight monthly gain
  • For the 6 months ending at the end of December, the index of leading economic indicators rose @ an annualized rate of 7.0% compared to 3.9% for the previous 6-month period, suggesting positive growth this spring
  • Existing home sales (a report of the number of previously constructed homes with a closed sale during the month. Existing-home sales make up a larger share of the market than new-home sales and indicate housing market trends) was up 1.0% in December and concluded 2013 with the best annual sales since 2006
  • 5.09 million existing homes were sold in 2013, up 9.1% from the previous year
  • The median price of previously-owned homes came in @ $197,100 up 11.5% from a year ago

For the week, the S&P 500 declined by 2.6%.

Summary:

IBD: Uptrend under pressure

BCI: Moderately bullish but with concerns regarding the current earnings season. This site is hedging with an equal number of in-the-money and out-of-the-money strikes.

Wishing you the best in investing,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

 

 

 

 

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

7 Responses to “Rolling Out And Up To Capture Share Appreciation: A Good Idea?”

  1. Barry B January 25, 2014 12:42 pm #

    Premium Members,
    This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor premium member site and is available for download in the “Reports” section. Look for the report dated 01-24-14.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:

    http://www.youtube.com/user/BlueCollarInvestor

    Since we are in Earnings Season, be sure to read Alan’s article, “Constructing Your Covered Call Portfolio During Earnings Season”. You can access it at:

    http://www.thebluecollarinvestor.com/constructing-your-covered-call-portfolio-during-earnings-season/

    Best,
    Barry and The BCI Team

  2. Barry B January 25, 2014 3:52 pm #

    Premium Members:

    This week’s Weekly Stock Screen And Watch List has been revised and uploaded to The Blue Collar Investor premium member site and is available in the “Reports” section. The Open Interest data was revised. Look for the report dated 01-24-14-RevA.

    Best,

    Barry and the BCI Team

  3. Robert Sexton January 26, 2014 3:21 pm #

    Alan,
    Thanks for another interesting article. I do have one question about this. Would there be any benefit to buying back the option and selling the next months higher strike (assuming no earnings and still favorable technicals), if you were to buy the option back when it crossed the strike price. My thought with this is to buy it back before it has packed on a lot of intrinsic value. You would only be buying back the time value which you would then recoup with the extra couple weeks on the next month options. I understand that this gives up on the first near term option falling back below the strike, but with all the technicals being positive and the stock up, the chances of that happening are marginal at best. Thanks again
    Robert

  4. Alan Ellman January 26, 2014 6:43 pm #

    Robert,

    I always admire and respect members who are trying to find new wrinkles to enhance gains. That said, your parameters as to when to consider rolling out and up (appreciating stock above the strike with strong technicals and no ER) is spot on. The question is when to consider executing this strategy and, in my view, it is not until expiration Friday is upon us.

    Covered call writing is all about capturing time value. By buying back an option mid-contract that was sold originally out-of-the-money and now near-the-money we are probably losing time value. In addition, we are now taking on a longer-term obligation and depending on share appreciation to compensate for time value lost.

    As far as intrinsic value is concerned, should we roll out and up near expiration Friday, we will be rewarded with additional share value so it becomes a wash and once again we are back to capturing time value.

    You bring out a good point that a stock that has been appreciating in value and has strong chart technicals has a good chance to continue to appreciate but there is no guarantee especially because overall market conditions can play a big role in price movement. To give up time value and depend solely on share appreciation almost becomes another strategy.

    My preference is to generate an intial return that meets my goal (2-4% in my case) and manage that position to mitigate losses, enhance gains and in some cases turn losses into gains. If a stock continues to appreciate above the strike, we have an exit strategy for that too…the mid-contract unwind exit strategy (see pages 264-271 of “Encyclopedia…”).

    Thanks for your thoughts…keep them coming.

    Alan

  5. Melody January 27, 2014 10:14 am #

    Dear Allen,

    Thanks for the article. I have been looking at support and resistance levels and selling the call at a strike price that captures both stock appreciation and time value. This also depends on the strength of the underlying stock. I have had the stock go beyond the strike price. I let it be assigned and waited for the pullback to take advantage of the stock. This actually worked well as the call premium rose due to investor enthusiasm. However, I do not think that this will work for every stock. The stock was just very bullish.

    Melody

  6. Alan Ellman January 27, 2014 11:04 am #

    World Money Show seminar in Orlando this weekend:

    To confirm, I will be presenting ONE seminar on January 31st from 5:15 to 6:15:

    http://www.moneyshow.com/tradeshow/orlando/world_moneyshow/speakers/speaker_details/?speakerid=891071A&scode=034233

    Hope to see as many BCIers as possible.

    Alan

  7. Alan Ellman January 29, 2014 5:47 pm #

    Premium members: New feature to our ETF Reports:

    This week’s 7-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site. The report also lists Top-performing ETFs with Weekly options.

    Based on member feedback, which is so important to us, it has come to our attention that some members have made the assumption that the ETFs in our reports are all low-risk securities with low implied volatility (IV). This conclusion was based on the fact that BCI is a low-risk approach to covered call writing and investing in general and furthermore ETFs are for those who are even more conservative in nature. A point well-taken.

    Our ETF screening process involves selecting securities that are out-performing the S&P 500 over the past 3 months, have a relative strength rating (price performance compared to overall market) above 60, have adequate trading volume and option liquidity in the form of open interest (OI) over 100 contracts for near-the-money strikes. Although most of the ETFs presented in our reports are of low implied volatility, some are not. As we have done throughout the years, when we can enhance the products we provide to our members we take action.

    Information provided on page 7 of the report:

    Our BCI team will be sharing the current implied volatility of the S&P 500 (SPX) and that of the eligible ETF candidates. This will allow our members to compare the expected movement of a particular security to that of the overall market. From there investment decisions can be made based on personal risk tolerance and overall market assessment.

    For your convenience, here is the link to login to the premium site:

    http://www.thebluecollarinvestor.com/member/login.php

    NOT A PREMIUM MEMBER? Check out this link:

    http://www.thebluecollarinvestor.com/membership.shtml

    Alan and the BCI team

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