With the recent recovery in the stock market, many investors are returning to the covered-call strategy for long-term portfolio issues.
Anyone who buys and sells stocks knows the market is unpredictable and when it comes to selling covered-calls, a trader must always be ready to make adjustments to keep a position profitable. When you use this strategy to generate income from the stocks in your portfolio, a bullish issue can be just as bad as a bearish issue if you don't know how to "roll" your options correctly and in a timely manner. Rolling out, or buying back the current short calls and selling new calls with a future expiration date and in many cases, a different strike price, is a technique that experienced traders utilize on a regular basis. Those of you who are not familiar with the basics of this method of position adjustment should review the covered-call chapter in Options As A Strategic Investment, by Larry McMillan.
The most common time to roll-out to new options is just before the current options expire but that doesn't prevent you from taking advantage of favorable moves in the stock or beneficial changes in the option premiums. The primary goal of any trade is to earn a profit and by the same reasoning, any adjustment to a portfolio position should attempt to improve its overall risk/reward outlook. Some traders roll their positions when the new cycle begins (when options two months out are posted) while others use the ratio of time value between the bought and sold options to determine the timing of the transaction. Another popular method is based solely on the premium remaining in the short call, which is an excellent indicator as it relates directly to the price of the underlying and the time remaining until the option expires. When this component reaches a level near parity (most of the time value has dissipated from the option's price) the position can generally be rolled to a
future expiration date for a substantial credit. However, if you wait too long to roll out (when the option bid has reached parity or a discount) there is considerable probability of early exercise by arbitrageurs; exchange specialists and floor traders who don't pay commissions for their trading.
In addition to understanding the different methods for timing the trade, it is also important for an investor to establish realistic goals when using this strategy. Experienced traders usually focus on the annualized target return or a specific percentage gain in order to determine the minimum profit required (in a given time period) for a particular position. Using this approach, a reasonable target for adept covered-call writers might be as high as 4-6% (8-12% on margin) monthly return on investment. Even with this meager yield, the long-term capital appreciation is excellent due to the unique mathematics of compounding. Obviously, some retail option traders would regard this target as far too low however earning only 3% per month, even without the effects of compounding, equates to a 36% yearly return. That's really the key to success with this strategy â€“ it allows investors to compound their returns on stock ownership each month of the year. The problem is, while most people begin selling covered calls with the goal of growing their account on a regular
basis, many lose focus of the fundamental outlook of the strategy (consistent, low risk profits) and begin to concentrate on higher, single-transaction returns. This is a common mistake and it can substantially increase losses, even with proper money management in a diverse portfolio.
One thing option traders must always be aware of is "slippage." Slippage is the difference between the prices you see when you get quotes for a trade and the prices at which the trade is actually executed. In the case of roll-out trades with covered-calls, the best way to avoid losses from slippage is to place the separate orders as a spread. To do this correctly, you should first calculate the difference between the option you are buying and the option you are selling. Then you place an order to "buy-to-close" the short calls and "sell to open" the new options for a specific price. Once you have established this "net" credit for the roll-out transaction, the combined order can be placed with a "good-until-cancelled" contingency that allows it to remain in effect until it is filled or modified due to changing conditions. Another popular variation of this technique is used when closing a losing covered-call play. Similar to a "buy-write," an order is placed to repurchase the sold option and sell the stock for a net credit. Again, the "net" amount is determined by the bid price of the stock and the ask price of the short call. Using this method allows in conjunction with a discretionary order gives the floor broker added flexibility to fill the order and it often results in a better outcome than if you tried to make the trades independently.