One of the most common option strategies is the covered call. But to use it well, you must understand how — and when — to roll your calls.
While there are many types of rolls, there are three you must know. So, what are they, and how do you do execute the rolls?
Remember that the covered call is a strategy where you sell one call against 100 shares of the underlying stock. For instance, say the stock is trading for $100 and you sell the $105 call for $2. That’s a covered call, and the risk graph looks like this:
Source: Market Rebellion
It’s called “covered” because you own the shares. Had you sold the call without owning the shares, you’d have unlimited upside risk. By owning the shares, that upside risk is eliminated, or covered, which is why the above risk graph is flat for all stock prices above the $105 strike. However, by owning the shares, you’ve switch to having unlimited downside risk. So, one of the most important considerations before writing calls is to be sure you’re comfortable holding the shares—that’s where the risk lies.
If the stock is $100 and you sold the $105 call, you can potentially make a $5 capital gain. In addition, you’ll earn the $2 collected from selling the call for a total $7 possible gain. However, the maximum you can make from the call is the premium collected, or $2 in this example. As time passes, the value of that call will decay toward zero if the stock remains below the $105 strike. At some point, it’s not going to make financial sense to continue holding the short call. It’s hard to say exactly when it’s not worth holding, but as a general rule, if 80% of the initial value has decayed, it’s probably time to roll it. So, the first roll you must know is the roll out.
Rolling Out
In options trading, we use the terms “in or out” to refer to time. If you’re rolling to a longer-dated option, you’re rolling out in time. If you’re rolling to a shorter-dated contract, you’re rolling in.
The roll out is done when the stock price has been quiet, but the option is about to expire, so you want to write a new call with the same strike. If it’s out of the money, you could let it expire and write a new one on Monday. But what if the stock price falls on Monday’s opening bell? Now you’re not going to have that option premium to act as a downside hedge, and if you still decide to write the call, you’re not going to receive as much money—a double whammy. Well, to extend the life of that contract on Friday, you just roll the contract out.
Whenever you roll an option, it’s best to execute the trade as a simultaneous order. By submitting both orders at the same time, you reduce the chance for execution risk which occurs if the stock makes adverse moves while submitting each order separately. By executing a simultaneous order, whether the stock rises or falls slightly, the net credit probably won’t be affected. So, what’s the best way to roll your call out?
Let’s say you’re short the June $105 call and want to roll to the July $105 call. You must buy the June $105 call to close and sell the July $105 call to open. Buying the June $105 call and selling the July $105 call is a short calendar spread. Let’s say that calendar spread is trading for a credit of two dollars. Go to your broker’s platform and enter an order to sell the June/July $105 calendar spread for a net credit of two dollars. When the order is executed, the June $105 call gets closed while the July $105 call becomes the short call. Your risk graph has shifted from the blue curve to the red:
Source: Market Rebellion
Notice that the bend still occurs at $105 since you’ve rolled to the same strike. However, because you collect $2 from the sale of the first call and another $2 from this roll, you’ve collected a total of $4, so your maximum gain is $9 ($5 capital gain plus $4 in option premiums), and your breakeven point is lowered from $100 to $96. If the stock price stays fairly calm, just continue to sell calendar spreads to roll your contract out. But what if the stock price rises? What if the stock is $105 or higher and you want to sell the $110 call?
Pete Najarian uses covered calls to hedge his investments. Discover how with Pete’s Covered Calls and learn the strategy professional traders use to defend their long-term stock portfolio.
Rolling Up & Out
If you’re short the June $105 call and want to roll to the July $110 call, you must buy the June $105 call to close and sell the July $110 call to open. Buying the June $105 call and selling the July $110 call is a short diagonal spread. In options trading, we call rolling to a higher strike a roll up while rolling to a lower strike is a roll down. If you execute a trade to sell the June 105/July 110 diagonal spread, the June $105 call gets closed while the July $110 call becomes the short call. You’ve rolled up and out. Let’s say the diagonal spread is also selling for a credit of two dollars. Once executed, your risk graph shifts from the blue to the red:
Source: Market Rebellion
Notice that the bend in the risk graph has changed from $105 to $110, so there’s another $5 of potential capital gains. When added to the $2 credit, that’s another $7 on top of the previous $7 maximum gain with the blue curve, so that’s why the red curve shows a maximum gain of $14. If the stock continues to climb past the strike each time you write calls, it’s easy to stay in the position by rolling up and out by selling diagonal spreads. What if the stock price rises past the strike before expiration?
Rolling Up
Let’s say you’re short the June $105 call, but the stock rallies past $105 prior to expiration. Do you have to call it quits and let the shares go? Not at all. If you want to stay in the covered call for the same expiration, you can roll the call up. To do so, you’d buy the June $105 call (close) and sell a higher strike, perhaps the June $110 call (open), which is buying the vertical spread.
Just go to your platform and enter an order to buy the June 105/110 vertical spread. When executed, you’re left with a short June $110 call. This trade will always be a debit since you’re buying back the lower-strike call and selling a higher-strike. For any expiration, lower-strike calls are always more expensive, as they give you the right to buy the shares for less money, so roll ups are always for net debits. For instance, if it’s a $2 debit, you’re buying the June 105/110 vertical spread, which increases your maximum gain by three dollars. After the trade, you’ll be short the $110 call with a maximum gain of $10. That’s because you had a $7 gain before, but you’ve now added another $3 to that maximum. Your risk graph shifts higher and moves the bend to the right, as shown from the blue curve to the red:
Source: Market Rebellion
If that’s difficult to understand, don’t think of the trade as part of a covered call. What if you just bought the June 105/110 vertical spread for $2? You’d have a max gain of $3, so that’s exactly what happens if you buy the spread while holding the shares. Rolling up is more of a speculative trade, as you’re investing more money in pursuit of greater profits.
There are other rolls you could do such as rolling down, rolling in, or rolling down and in. However, if you start by understanding the basic rolls outlined here, you’ll have more success with covered calls. You’ll have more ways to optimize the strategy based on market conditions, and when you have more choices, you’ll have better results. Learn your rolls, and you’ll find the covered call strategy isn’t so basic after all.
