October 31, 2003

The Tactical Unwind:
Taking money off the table.
By John Brasher, CallWriter Publisher

One of the knocks on covered call writing is that it supposedly leaves the trader exposed to massive losses if the underlying stock falls, while simultaneously limiting the call writer's potential return. The biggest knock is the notion that when the stock moves up sharply, the covered call writer can only helplessly watch the move happen and has to settle for the poor little premium received, unable to share in that lovely price appreciation.

Don't be a fool, Motley...

Our first thought is that if 5% monthly or more (without margin) is not good enough for the mandarins of the how-you-should-trade-your-money industry, too bad. We here at CallWriter like 5% a month just fine. Second, there actually is a way to increase your return if a stock runs up. Maybe Motley Fool customers would sit idly by, but we at CallWriter would not. And neither would our many students who have learned to use our proprietary tools. The following strategy is very important to the covered call writer. In fact, if you DO NOT follow the advice below when one of your covered call stocks advances sharply, you will simply be letting the market pick your pocket. Here's how to take you money off the table when the stock runs up.

Let's move on to a concrete example:

This example is based on a real trade, and the result below is not uncommon. Let's say you find a $53 stock with the current month's 55 call option selling for a $4.50 premium, which is a respectable 8.49% flat return. Your research results in a strong thumbs up. Selling the 55 call reduces your cost basis in the stock to $48.50. And if you are called out at the $55 strike price, your total return will be 12.26% (the $4.50 premium you already received, plus the $2 profit over your $53 cost basis). A $53 stock is fairly high for a covered write, but the dynamic discussed below occurs on stocks of just about every price range.

As luck would have it, a strong buy recommendation the next week runs the stock price up to $63.50, and the $55 call now is selling for $9.50! If the stock stays above the $55 strike, you will be called out and realize the 12.26% return. Most people would not complain about a 12.26% return for a month. But truth be told, if the market puts more money on the table, why not take it? Let's not be greedy, but let's do be sensible. If you wait to potentially be called out at the $55 strike, you will forfeit all that incredible price appreciation and also risk the stock declining before expiration.

So the question becomes, could you lock in the return or do even better?

There is a strategy we call the Tactical Unwind. (Basically, this is CallWriter's term for buying back the calls sold and selling the stock before expiration just because it is economically advantageous to do so.) To calculate the numbers on a tactical unwind, several calculations must be made, and it's easy to screw up these calculations. Plus you have to recalculate every time the stock price or option premium changes. Ouch! This is precisely why we invented the CallWriter Covered Call Position Management Calculator™ - it runs the necessary unwinding calculations for you instantly. We designed it for our own trading, and we use it almost daily to monitor trades. Let's use the calculator now to examine the best course of action for this trade.

Option 1: Let the calls be exercised.
In the first line of the calculator, you would enter the trade details, the $53 price paid for the stock, the $55 strike price and the $4.50 premium, and it would show you the 8.49% and 12.26% returns. If you simply wait for the calls to be exercised, your trade results will look like this:

Not a bad trade result at all. With the stock at $63.50, getting called out on the 55 strike is a dead certainty, IF the stock remains above $55, of which there is no guarantee. When using the calculator, remember the old adage about chickens that have not yet hatched... Now let's look at the results of a tactical unwind.

Option 2: The Tactical Unwind.
The Tactical Unwind is simply unwinding the covered call trade before expiration day. Keep in mind that you always have the right to unwind a covered call trade, any time you want. You unwind it by simply buying back the calls sold and selling the underlying stock. It's tactical in this case because we are doing it specifically to better the return on our position. It's that simple.

Now that the stock and call prices have changed, it is time to enter the new prices into the second line of the calculator and see if there is any extra profit to be realized from a tactical unwind. So you enter the new $63.50 stock bid price (the price you'll get if you sell it) and the $9.50 asking price for the call (the price to buy it back).

Well, at a glance 10.37% is not an improvement. Unwinding the trade would lower the return from 12.26% to 10.38% and add an extra commission cost. 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. If you let the shares be called out you only pay one commission to sell the stock. Unwinding the trade is an absolute necessity when the price declines and hits your stop. But unwinding when the stock moves up doesn't always work, because the calls sold are now in the money and increase in price dollar-for-dollar with the stock.

So does the Tactical Unwind make sense in our example?

Remember, there are two major factors to weigh when considering a tactical unwind:

1)  You haven't yet realized that 12.26% return yet. The stock went up, and it could go back down.
2)  You have to sit in the trade another three weeks to get the 12.26% return essentially locking up your capital.

A tactical unwind right now would lock in the 10.37% return, terminate all trade risk and free up your trading capital. So, which is better: 10.38% for a 1-week trade, or 12.26% for a 4-week trade? Here's a big hint: 10.37% for one week works out to a roughly 41.5% monthly return!

But can we do even better by rolling the calls?

Option 3: roll up to the 60 call.
Since the calculator is also built to calculate rollovers, let's look at a potential roll up into the 60 call, which we enter into the third line of the calculator. We input the 60 strike price and the $5.50 premium for selling the call and here is the result:

How can this higher return be when you had to buy back the call for $9.50? Simple: you got $4.50 to begin with, subtract the $9.50 to buy back the 55 calls, add $5.50 for selling the 60 calls, and factor in the extra $5.00 you get for selling the stock at the new $60 strike. (OK, so it's not simple, that's why we use the calculator!) This roll is showing us a 14.15% return, but you have to stay in the trade another three weeks to get it. Not a bad return at all for a one-month trade, but is it better than getting 10.38% for a 1-week trade? Don't forget, too, that you get the 14.15% return if and only if the stock still is above $60 at expiration.

Option 4: roll up to the 65 call.
But wait, there is one more possibility: a roll up to the 65 call. This second roll possibility goes into the fourth line of the calculator. So we input the 65 strike and the $3.00 premium for selling it, and the calculator shows us:

Let's work the math to see how the calculations work. You got $4.50 for selling the 55 calls. Now subtract the $9.50 to buy back the 55 calls, add $3.00 for selling the 65 calls, and factor in the extra $10.00 you get for selling the stock at the new $65 strike. This roll is showing us an 18.87% return, but again you have to stay in the trade another three weeks to get it. This is a superlative return for a one-month trade, but is it better than getting 10.38% for a 1-week trade? Don't forget, too, that you get this higher return if and only if the stock still is above $65 at expiration, and it might be out of gas by expiration.

Wrap-Up
The math of rollovers can get complicated, no doubt about it. This is why CallWriter's Position Management Calculator™ is such an important tool. It does the hard calculations for you and shows you where the money is. Use it, and you'll find the additional profit lurking in a lot of trades. But don't just use the calculator to crunch trade numbers: pay attention to what it really is telling you. As the above examples indicate, you can't look just at return calculations. You have to remember that the trade ain't over yet, and the stock could pull back. You also have to factor in the time value of money. Below is a picture of our with the calculations discussed above factored in:

By the way, simply buying the stock at $53 and selling it at $63.50 (the Motley Fool way) would give you a 19.8% return, which is only very slightly better than the 18.86% return you would get from rolling over into the 65 call. That roll almost duplicated the long stock buyer's return! And the 19.8% is absolutely dwarfed by the 41.5% monthly return obtained by the tactical roll! But the long stock buyer would get that 19.8% return, or any return on a simple long stock position, only if the stock went up; and that was never guaranteed. In the meantime, the call writer was smart enough to sell the calls, making a fine return whether or not the stock went up as hoped!Then when the stock soared, the savvy call writer was quick to take the extra money off the table. Some might sniff that the original $4.50 premium wasn't a huge downside protection if the stock dropped, but the trader who merely bought the stock had no downside protection at all.

Traders frequently analyze things differently. But I can tell you that we at CallWriter would prefer to unwind the trade to get the 10.38% return and run another trade. With three weeks left before expiration, there certainly will be some fat trades out there. We can't emphasize this enough: the percentage return is meaningless unless you are comparing like time periods. And the return isn't certain (or even determinable) until the trade is concluded. If you decide to stay in a trade, be aware that there is no guarantee where the stock will close at expiration. You'll never go broke taking a fat profit.

Some of you may be thinking, wait a minute... didn't you write this same article just last week? Nope. Last week we discussed how and why to roll out to the next month on expiration day in order to get a much higher return and keep from being called out of the position. Today's article teaches the technique of tactical rolls to take more money off the trading table when there is time left in the trade. It's a good tactic, don't be afraid to use it!

Good luck and good trading!