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:
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:
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:
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.
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:
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%.
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 ([email protected])