Anyone can write a covered call. Managing these positions is just as critical as the stock and option selected. This article will review the process of the rolling exit strategies. I will use a real-life example taken from the Blue Collar Weekly Stock Screen and Watch List. The figures you will see are based on the options chain after market close on November 10th, 2011(I will normally use the rolling strategies closer to expiration Friday but since these articles are published on weekends I will use earlier stats). The stock that I have selected is Red Hat (RHT) which has been on our premium watch list for 4 weeks and is bolded as having passed all BCI screens. This means that, as of the most recent report, RHT is still a candidate for our covered call consideration. It currently meets all of our fundamental, technical and common sense requirements. Here is RHT as it appears on our running list:
RHT on our Premium Running List
For purposes of establishing a foundation for this exit strategy trade we will assume an initial purchase of 100 shares @ $48 and the sale of the November $48 (at-the-money) call for $2.20. As of market close on Thursday November 10th, the share price was $49.07 and the “ask” price for that option was $1.95. Here is the options chain:
RHT- November Options Chain
Now that we know what it will cost to close our short options position, let’s look at the options chain for December, the upcoming contract month:
RHT- December Options Chain
Here we see that if we roll out to the December same-strike $48 call we can generate $3.20 per share and if we roll out and up to the December $50 call, we will generate $2.10 per share. Our next step is to feed this information into the blue cells of the “what now” tab of the Ellman Calculator:
Ellman Calculator- Blue Cells
All the information fed into this spreadsheet was gleaned from the options chain. The results appear in the white cells on the right side of the page:
Ellman Calculator- Results
Evaluation of calculation results:
Rolling out (yellow highlighted areas)
- Closing and opening the short option positions results in a credit of $125 or a 2.6%, 1-month initial return.
- The downside protection of that 2.6% return is $107 or 2.2% ($107/$4907).
This means that our 2.6%, 1-month profit is guaranteed as long as share value does not depreciate by more than 2.2% in the contract month.
We consider a rolling out strategy when we still like the underlying security, the returns meet our 2% – 4%, 1-month goals and market conditions are such that additional protection is indicated.
Rolling out and up (green highlighted areas)
- Closing and opening our short option positions result in a credit of $15.
- The share value is “bought up” from the previous strike ($48) to the current market value of $49.07 or $107 per contract (purple highlighted area).
This results in an initial credit of $122 or a 2.54%, 1-month initial return.
Additional profit (upside potential) of $93 can be generated if share value appreciates to or beyond the $50 strike.
This would result in a total credit of $215 or a 4.48%, 1-month return.
We consider a rolling out and up exit strategy when we still like the underlying, the returns meet our 2% – 4%, 1-month goals and market conditions are favorable for continued share appreciation.
When considering rolling strategies on or near expiration Friday we follow these steps:
- Determine if the underlying security meets our system criteria. Stocks on our “premium running list” are eligible.
- Check the option chains for the current and next month stats.
- Enter those stats into the “what now” tab of the Ellman Calculator.
- Make sure the initial returns meet our 1-month goals of 2% – 4%.
- Evaluate market conditions and chart technicals to determine if downside protection is indicated.
Now start cashing in on covered calls!
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.