Today is expiration Friday for the June 2008 equity options (tomorrow, Saturday, is actual expiration day). If you are short ITM options at or close to expiration and do not want to lose the stock, meaning have it called away, here are two techniques that allow you to keep the stock:

1) Buy back the short ITM calls, which will be down to parity (trading at intrinsic value) or close to it. If the stock has advanced, this is an expensive prescription, because the call’s intrinsic value will rise with the stock price. But this is a poor practice, because it adds to the cost basis in the stock. In other words, the stock price will be below the position’s cost basis. The only justification for closing ITM calls is an expectation that the stock will rise in the short term, recouping the cost of buying back the calls. If the stock pulls back, the stock will be below cost basis. Thus closing ITM calls should be reserved for those instances in which you have a short-term bullish outlook on the stock.

As a side note, the market may well have bottomed temporarily, as noted in my most recent issue of the Money Newsletter. If so, good stocks will be rising in the short term. Weigh this alternative with the one below.

2) Roll the calls out to the next month, meaning to buy back the short ITM calls and sell calls of the same strike price for the next expiration month. Because premium will be higher for the next month, rolling up should generate a credit, not a debit. The roll out allows you to neatly skip over assignment this month and defer it. If the assignment is presented again at next month’s expiration, you can roll out again.

You may be able to roll up and out to the next month for a modest debit (I personally don’t add debits unless they are nominal) - or roll up and out two months. In a strong bull market, this may make more sense, because stocks can rise for a long time without a meaningful retracement.

A frequent question I get about rolling out is: isn’t it just deferring the inevitable? Not really. Remember that YOU choose whether you are assigned or not. If we posited that the underlying stock will keep rising forever, then rolling out would indeed only postpone the day of reckoning. But that does not happen. Sooner or later the stock will retrace and give a breathing space to close the short calls. In a volatile or bear market (like the one we have now) a pullback is pretty much assured.

If you roll out, you can always close the new calls - that option always is on the table.

This entry was posted on Friday, July 18th, 2008 at 10:27 am and is filed under Covered Calls, Trading Tips. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.