October 23, 2003

Analysis of a Covered Call Roll Vol I:
How to analyze the trading possibilities
By John Brasher, CallWriter Publisher

Sooner or later every covered call trade comes upon expiration day. When the trade is ahead and obviously going to produce the hoped-for profit, the weary trader can relax and simply let the stock be called out and pocket the profit. But what if there is still more money to be taken off the table? This happens sometimes, and the purpose of this article is to demonstrate how a covered call writer should analyze the various "options" available on expiration day.

Roll up, roll out, roll down?

Let's take a look at an actual CallWriter trade that was rolled out to the following month to demonstrate how a roll is done and how the covered call writer analyzes the trade possibilities. On Sept. 17, a covered call trade was run in USG Corp. (USG): USG was bought at $17.98 and the Oct. 15 call options were sold for a $3.70 premium, which at the time of the trade set up a profit potential of 4% for a 30-day trade. On expiration day (Oct. 17th) USG had dropped a bit but was still over $17. However, it was certain that the USG shares would be called out to terminate the trade, since the Oct. 15 call sold was deep in the money. It was also clear from looking at the CallWriter Real Time Lists™ that USG was still a strong performer, because the technicals were strong and USG November calls were paying even higher premiums.

The trader's choice on expiration day is to passively wait to be called out or try to wring even more profit out of the trade. Being called out was no bad thing, since one cannot complain about a 4% return for a 30-day trade duration. But if there is more money to be had with relative trade safety, shouldn't you take it? The answer is: why the heck not? The only way to extend a covered call trade about to go to assignment (being called out) is to buy back the calls already sold and sell new calls, which is known as a "roll". But the calculations are a bit complex and impossible to do in one's head. In fact, the calculations are tough to do with a standard calculator.

So the real question is, how do you decide if there is more money in waiting to be called out or continuing the trade to produce a larger profit? How in fact do you know if there is more profit in actively managing the trade? This question is precisely why CallWriter invented the Covered Call Trade Management Calculator™, a proprietary tool designed to show you where the most money is in a covered call trade. Use of our calculator is simplicity itself. You input the trade numbers into the calculator, input the current price and the cost to buy back the short calls, and then input the strike price and premium of the new call to be sold. It really is that simple, and the calculator shows you where the money is.

For those of you who like to read ahead and get the ending, we decided the best course was to "roll out" to the November 15 call, meaning to buy back the Oct. 15 calls before they were exercised and sell the Nov. 15 calls. It cost $2.23 to buy back the Octobers and we got $3.64 for selling the Novembers. This raised the total net premium received from the original $3.70 to $5.11. Below we will analyze the choices we faced from a trader's perspective and why we made the choices we did.

A "roll" is simply the repurchase of the call options sold and the sale of a different series of call option. Selling a higher strike is "rolling up," selling a lower strike is "rolling down," and selling calls with expiration dates further out is "rolling out." Here is how the transaction looked in table form:

Aaah, but how did we come to this decision? Let's get into the logic of the trade right now...

First, Get the Information

On expiration day there were three choices: 1) let the shares be called out, 2) unwind the trade by buying back the Oct. 15 calls and selling the USG shares, or 3) rolling into a new call series by buying back the Oct. 15 calls and selling new calls. At the time this decision was being weighed, USG had dropped to $17.11, the November 15 calls were selling for $3.64 and the November 17.50 calls were selling for $2.65. It would cost $2.23 to buy back the Oct. 15 call in order to do the roll. Great information, but where is the money? We input the numbers into the calculator, and here is what it showed us:

Let's go through the calculator's math for the four different scenarios. You might disagree with my read on these possibilities, and that's fine with me, but I want you to understand how the analytical process should be done on rolls, and how to use our Covered Call Trade Management Calculator™ to make the decision.

Option 1: Let the Calls be Exercised

The table above simply shows the result from doing nothing at expiration and letting the calls be exercised. These numbers reflect the result shown in the first row of the calculator. Let's do the math for the four different possible scenarios:

Simply letting the trade end yields a 4.1% profit, which would have been a nice return for a 30-day trade, and only one commission is involved upon selling the shares of stock. You pay no commissions when your short options are exercised. The reason the profit would be only $0.72 despite receiving a $3.70 premium upon trade entry is that the Oct. 15 call was $2.98 in the money (17.98 - 15.00). Deducting $2.98 from the $3.70 premium leaves a $0.72 profit upon being called out.

Option 2: Unwind the Trade

But can we do better by unwinding the trade and selling the stock? This is what the second row of the calculator shows us. We enter the current stock price ($17.11), which is what we get by unwinding the trade, and the $2.23 cost to buy back the call:

Nope, 3.33% is not an improvement. Unwinding the trade would have lowered the return from 4.1% to 3.34% and added commission costs, since if you let the shares be called out you only pay one commission to sell the stock. Because you unwind a covered call trade by repurchasing the call options you already sold and selling the underlying shares of stock, unwinding costs you two commissions: one to buy back the calls and one to sell the shares. Sometimes the most money or smallest loss is in unwinding the trade, but not this time.

Option 3: Roll out to the November 15 Call

Let's look at a potential roll out into the November 15 call, which is what the third row of the calculator tells us. We input the 15 strike price and the $3.64 premium for selling the call and here is the result:

This rollout is showing us a much better return, but you can't look just at this number, you have to analyze the trade just a wee bit more. Yes, the rollout increases the profit potential from 4.1% to 11.84%, but remember that you will be in the trade an additional 34 days if you roll into a November call. The original October trade lasted 30 days (Sept. 17 to Oct. 17), and rolling out to November means as additional month, essentially doubling the trade time. Yet 11.84% is well over double the original profit potential of 3.99%, so this roll is worth the effort. Notice how we keep talking about the profit potential instead of a return? This is because profit can only be determined upon trade conclusion, and the trade ain't over yet.

Trading Tip:  You have to look at time in the trade to determine the real return or profit potential. If, for example, the roll increased the return only to 7% while doubling the trade time, you would actually be losing money. Why? The original profit potential was 4.1% for 30 days, so you would have to get slightly over 4% for the second 30 days - meaning a total return for 64 days of over 8% - in order for the roll to produce a higher profit. Put differently, a total return of 7% for two months would average out to a 3.5% return. You were already scheduled to get 4.1%, so why cut your returns? Remember that time is money.

Option 4: Roll out to the November 17.50 Call

But wait, there was one more possibility: a roll up and out, meaning rolling to the November 17.50 intead of the 15 strike. This second roll possibility goes into the fourth row of the calculator. So we input the 17.50 strike and the $2.65 premium for selling the Nov. 17.50 and the calculator shows us:

Seems complicated? It's not. This is what our calculator is made for. It does the hard calculations for you. Use it, and you'll find the additional profit lurking in a lot of trades.

This is the analytical point where a trader's eyes pop out and he or she gets cold chills. Great googly moogly, the profit potential shot up to 18.07%, an average of slightly over 9% per month! But as you saw above, we passed on the Nov. 17.50 and rolled into the November 15 call. Here's why. First, you get an 18.8% if and only if USG is precisely $17.11 at expiration, because the calculator is programmed to show the roll possibilities based on the assumption that the stock price won't change by expiration. Why do we program this assumption in? For one thing, we must use the current stock price in order to do the second-line unwinding calculation, since this is designed to show the immediate economic effect of unwinding the trade at that price. And once the second-line calculation is run, it makes the most sense to use the same stock price for the rolls in lines 3 and 4. More to the point, what stock price would make more sense than the current price to base the roll calculations on? Allowing traders to enter any other stock price would only invite them to pick an arbitrary price they think, wish, hope or dream the price may be at expiration, which certainly wouldn't be any more valid or useful than using the current price. To wrap up the 17.50 strike calculations: If USG finishes below $17.11 at Nov. 21st expiration you will get less than the 18.8%, and if it is higher than that you would get a higher return. The 20.25% return if USG were called out at the 17.50 strike is the highest return possible from rolling into that strike.

Second, the market was a bit toppy at expiration. It went up to 9850 on comparatively weak volume and pulled back. Weak runups and weak pullbacks don't engender a lot of confidence, and USG can be expected to follow the market. Third, USG has been showing the high returns in large measure based on market speculation about the resolution of huge asbestos-claims litigation. Bad news on that front would virtually assure that the 17.50 call doesn't get exercised. Fourth, USG itself is toppy: on Thursday Oct. 16th it hit the $18.70 resistance level for the second time since it went into the current trading range in July and was pulling back. As the chart below indicates, USG seemed at least as likely to be below $17.50 at November expiration as above it.

USG Chart 10-17-03

Making the Roll Decision

So, what's a covered call writer to do? We're conservative by nature, and we figure that USG is more likely to get called out at $15 than $17.50 - a lot more likely. We like getting called, because it wraps the trade up and terminates trade risk, incidentally freeing up our trading capital. Also, rolling out to the Nov. 15 call reduced the cost basis in USG all the way down to $12.87. So unless USG goes off the cliff and falls below $12.87, you can't take a loss. Writing the 17.50 reduces cost basis to $13.86, but that's just not as much protection as from writing the 15. Because USG has traded heavily in the past months and established a new trading range, we are fairly confident that the stock presents comparatively little danger for traders at the 15 strike. Finally, lowering our basis to $12.87 puts the breakeven point below the lowest support level ($13.05), and our preference (when possible) is to write covered so that our breakeven is below support. $12.87 is below the $13.05 support level and waaaay below the $14.50 support level. When your breakeven is above support, on the other hand, you have to make a decision about unwinding the trade before knowing if it will find support again and bounce back.

Playing with the Calculator

The more adventurous traders may be thinking at this point that I've missed the boat: that the real money is in the 17.50 strike. But consider a few things first. Suppose that USG finishes at expiration well below the current $17.12 price? By inputting a different price than the actual current price in the "current price" box on the second line, you can experiment with different unwinding returns in line 2 and different roll returns in lines 3 and 4. (But be sure to input the correct current cost to buy back the call sold!) By experimenting thus, we observed that if USG finished at $15.99 at expiration, the return from rolling into the Nov. 17.50 would be 11.85%, exactly the same as writing the Nov. 15 call and getting called out. However, playing with the calculator also shows us what happens if USG closes at $15. In this event the Nov. strike would not be called out and the return from the Nov. 15 strike would be 11.85% (because the stock would be sold at $15, the same as if called out), but the return from the Nov. 17.50 would shrink to 6.35%, which would be the total return for 66 days in the USG trade (October and November). Play with the calculator yourself and you'll see what we mean.

So if you think USG has a better than 50/50 chance of closing over $15.99, then you would write the Nov. 17.50. If you are more concerned about USG in light of the asbestos litigation (like we are), then you prefer the safety of the Nov. 15.

In covered calls you are always balancing premium, downside protection and stock analysis. You can't make consistently good returns always focusing primarily on just premium or just stock analysis. Remember, pigs get fat, but hogs get slaughtered. We hope this was helpful and will present other roll articles in the future to help you work through the logic of rolls, which can be a lovely thing!

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DISCLAIMER: We are not brokers, investment advisers or securities analysts and do not recommend the purchase, sale or holding of any security. Your use of any information or strategy appearing in this newsletter or on CallWriter.com is solely at your own risk. We urge our newsletter subscribers and CallWriter.com website members to do all requisite analysis and properly plan each trade prior to making the trade and to manage each trade effectively. Covered call and other potential trades discussed in this newsletter or on CallWriter.com do not constitute trading recommendations by CallWriter or any other person and are presented solely for informational and educational purposes.