Traders, especially covered call writers, love the forward roll. It helps avoid or defer exercise, creates additional income, and helps keep ownership of stock that is on an uptrend.
But there are potential problems. Among these are the following four every covered call writer needs to remember:
1. Rolling keeps you exposed longer, tying up capital. As advantageous as it might look to roll forward, does it really make sense? When you roll, you buy to close the original position and replace it with a sell to open, later-expiring new position. But this means you keep yourself exposed to exercise risk for the extended period of time. The question becomes: Does rolling make sense? Sometimes it does and sometimes it does not.
2. Unless you roll to the same or a higher strike, you could end up losing. Some traders, intent on avoiding exercise, roll calls to a lower strike. This is a big mistake. The lower strike means you get a lower capital gain if and when the call is exercised. So you have to hope for a decline in the stock's value in order for the call to work. But this means the profit in the call - if it materializes - will be offset by a smaller capital gain (or a loss) in the underlying upon exercise.
3. It makes more sense at times to take a small loss or even accept exercise. Given how close the outcomes are in many rolling instances, and also thinking about the risk coming from extra time exposed, you might be better off buying to close at a loss and waiting out a better covered call situation. You could also keep the position open and accept exercise. If you picked the call wisely and created a capital gain and option premium profits, exercise is not a bad outcome.
4. You could end up with unintended tax consequences. The tax rules for options are among the oddest of all. One rule is involved with what are called "unqualified" covered calls. Under this rule, if you sell a covered call deep in the money (usually meaning more than one strike increment below current strike) you could have the period leading up to long-term treatment of the underlying tolled, meaning the count is stopped as long as the short call is open. For example, if you own stock for nine months at the time you open a covered call, and you then roll to a later call which ends up getting exercised, you could lose your long-term capital gain on the stock. This applies only if the call is unqualified, and if it is exercised after the one-year period has passed. There is a lot to considered when managing your covered call transactions. You might see this strategy is simple and profitable, until it gets complicated and unprofitable.
To discover more about tax rules on options, download the free report from the page Taxation of options
Michael Thomsett blogs at the CBOE Options Hub and several other sites. He is author of 11 options books and has been trading options for 35 years. Thomsett Publishing Website