How to roll

April 20, 2016 09:00 AM

Covered call writers love the forward roll. It helps avoid or defer exercise, creates additional income and helps keep ownership of upward trending stocks. But there are potential problems. Among these are the following every covered call writer needs to remember:

Exposure

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.

Cutting profit potential

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.

Failure to take loss  

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 the risk coming from greater time exposure—you might be better off buying to close at a loss and waiting out a better covered call situation. You also could 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. 

Talk to any successful trader and they will tell you that some of their best trades are losers. Not every trade you take will be successful. The key to long-term trading success is to get the most profit out of the trades you called correctly and minimize losses when you are wrong. Traders who refuse to admit they are wrong turn what should be small inconsequential losers into big losers. 

Swapping long-term for short-term gain

You could end up with unintended tax consequences when you roll your covered call in what are called “unqualified” covered calls. Under this rule, if you sell a covered call deep in-the-money you could have the period leading up to long-term treatment of the underlying rolled, 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, 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. The period counted only goes up to the point where you opened the new call. So you could open a qualified position; but then the stock moves up, you roll forward to a later expiration and end up with an unqualified and a higher tax consequence.

Rolling your covered calls is only appropriate in certain situations. “Should I stay or should I roll?” shows an example in Caterpillar of when to and when not to roll.

About the Author

Michael Thomsett is author of 11 options books and has been trading options for 35 years. He blogs at the CBOE Options Hub and several other sites.