Rolling options is an important exit strategy choice when selling covered call and put options. Options can be rolled up and down in the same contract month or a future contract month. For the most part, we roll down in the same contract month and roll out or out-and-up in the next contract month. I recently wrote an article evaluating a trade executed by one of our members where an option was rolled up in the same contract month, an approach I rarely subscribe to. In this article we will evaluate another real-life trade by one of our members (we have a great group!) where an option was rolled out. The two-month results were positive but could they have been better?
The initial trade with VRX: Month 1:
- 5/26/2015: Buy 100 VRX at $234.60
- 5/26/2015: Sell 1 x June $240.00 call at $4.50
- 6/17/15: Early on expiration Friday the stock was still trading near $234.60
Let’s feed this preliminary information into the multiple tab of the Ellman Calculator:
VRX- Initial Calculations
We see a respectable 1.9% initial return with the possibility of an additional 2.3% from share appreciation. Because share price remained stagnant, the actual one-month return was 1.9% or 23% annualized. Very nice so far.
The second trade with VRX: Month 2:
The option was rolled out to the next month $240 strike. This involved closing the June $240.00 contract (BTC) and opening the July $240.00 contract (STO). The option credit for these trades netted $0.20. Then, mid-contract, the option was rolled down to the $235.00 strike. Here are the trades in month 2:
- 6/17/2015: Rollout to the July $240.00 strike for a net credit of $20.00 for the contract
- 7/8/2015: BTC (buy-to-close) the July $240.00 call at $2.35
- 7/9/2015: STO (sell-to-open) the July $235.00 call at $4.50
- 7/17/2015: VRX was trading at $240.00 level and shares were sold at $235.00
Calculating 2-month returns
The shares were purchased at $234.60 and sold for $235.00, a net credit of $40.00 for the 100 shares (less small trading commissions). There were option credits of $450.00 + $20.00 (includes rolling option debit) + $450.00 = $920.00. There was an option debit of $235.00. The net option credit was $685.00. The total position credit was $685.00 + $40.00 = $725.00 which calculates to a 2-month return of 3.1% on a cost basis of $23,460.00. This annualizes to 18.5%. On the surface this looks pretty good especially when we compare it to other investment choices we have these days.
Could the trade have been improved?
As Blue Collar Investors, we are always looking for ways to elevate our returns, even good ones, to higher levels. A 3.1% 2-month return appears reasonable on the surface but of that total, 1.9% was generated in month 1. The remaining 1% was generated in month 2 so therein lies the weakness of this 2-month trade. It seems that the option from month 1 was rolled when there was no need to do so. The share price was much less than the strike ($240.00) and so allowing the option to expire worthless was the prudent thing to do (take no action). That would eliminate any time value spent to close the near-month option plus eliminate one commission. Since the shares would not be sold, the next month option could be sold on Monday. Let’s make the reasonable assumption that the time value remaining on the near month option was $0.10 and so the next month $240.00 strike sold for $0.30, leaving a net credit of $0.20. Even if the option wasn’t rolled the initial return of the next month option ($0.30 is our educated assumption) only generated 0.12% initial profit, far too little.
How to improve this 2-month trade
- First, don’t roll the option
- Sell a lower strike if VRX was still maintained as an underlying security, probably the $235.00 strike which was used late in the contract
- Using the $235.00 strike would have generated a significantly higher time value return especially if it was used early in the contract. It is reasonable to assume the return would be greater than the $4.50 originally generated in the near month trade (which had a higher strike of $240.00).
- If the calculations for VRX did not meet our goals, sell the stock and use a different security
Discussion
Exit strategies like rolling options are absolutely critical to maximizing covered call returns. There are times when these strategies should and should not be used. Setting goals for initial monthly returns is one way we are guided to proper decisions. For example, if a trader sets a goals range for monthly returns of 2-4% as I do, a rolling return of 0.12% would never be given consideration. That said, the trade was an overall success and I commend our member for the way it was managed. Now let’s take that 18% annualized return and bump it up even higher.
Next live appearances
1- St. Louis, Missouri
September 15, 2015
6:30 PM – 9 PM
2- All Stars of Option Trading
September 16, 2015
Discussion panel
New York Stock Exchange
4:20 PM – 5:15 PM
Market tone
Financial markets took a breather from recent volatility, and global stocks generally rebounded after a run of daily losses ended Monday. US data releases were mixed. This week’s economic reports:
- US GDP grew at an annualized pace of 2.3% in the second quarter, below the median economist forecast of 2.6%. First-quarter GDP was revised up to 0.6% growth from the 0.2% contraction reported previously. Growth was the result of an increase consumer spending and strengthening labor and housing markets
- The Fed’s two-day July meeting ended Wednesday with no policy action and only minor changes in the post-meeting statement
- The employment cost index rose a seasonally adjusted 0.2% in the second quarter, the smallest quarterly gain since recordkeeping began in 1982. Sluggish wage growth could cause the Fed to wait longer before raising interest rates
- US home prices continued to rise but pending home sales fell and the home ownership rate sank to a 48-year low
- The S&P/Case-Shiller Home Price Index rose 4.4% in the 12 months ended in May, up from 4.3% in April
- Pending home sales declined 1.8% in June after five straight monthly increases
- The home ownership rate dropped to 63.5% in the second quarter, the lowest since 1967
- US nondefense capital goods excluding aircraft, a key proxy for business spending plans, increased 0.9% in June after falling 0.4% in May
- Overall durable goods orders rose 3.4%, driven by an 8.9% jump in orders for transportation equipment
- The University of Michigan consumer sentiment index fell to 93.1 for the final July reading down from 96.1 in June and below the median economist forecast of 94.0
- The Conference Board’s index of consumer confidence dropped to 90.9 in July from a downwardly revised 99.8 in June. The current reading is the lowest since September 2014, and the monthly decline was the steepest since August 2011
- Initial US jobless claims rose 12,000 to 267,000 for the week ended July 25th
- Continuing claims climbed 46,000 to 2.26 million for the week ended July 18th
For the week, the S&P 500 rose by 1.16% for a year-to-date return of 2.18%.
Summary
IBD: Uptrend under pressure
GMI: 5/6- Buy signal
BCI: Cautiously bullish using an equal number of in-the-money and out-of-the-money strikes.The Fed watch continues with a probable rate hike of 25 basis points in September or December. When it occurs, it may temporarily spook the market.
Wishing you the best in investing,