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Covered Call Writing: Rolling For Credits (13:03)

This article was originally published in The Option Strategist Newsletter Volume 13, No. 3 on February 12, 2004. 

Also known as the incremental return concept of covered call writing, this form of selling options against stock that is owned has several benefits that most investors don't realize. The goal of this strategy is to allow stock appreciation for a block of common stock between the current price and a selected target sale price, while also earning an incremental amount of income from selling options. The target sale price can be substantially above the current stock price. The typical investors positioned for this strategy are those with large stock holdings, interested in increasing current income, and wanting to refrain from selling the stock near current levels.

McMillan Analysis Corp. has proprietary software that analyzes such situations, and can present the client with scenarios outlining how the strategy would do under volatile stock movements. The worst case scenario occurs if the stock climbs straight to your target in a relatively short time period. For example, assume 10,000 shares of General Electric common stock are owned and a target price of 45 is agreed upon. With GE currently trading at 33, we can project what the options would sell for at various points along the way if GE rose swiftly from 33 to the target price of 45. The Black-Scholes model needs several inputs to perform the proper projection. While dividends, time assumptions, and price targets are all essential, the most significant is volatility since that is such an important factor in determining an option's price. GE's current implied volatility of 21% is in the 5th percentile of the past 600 trading days, so using 21 % for projections would be a very conservative estimate considering that it is usually higher than that. An increase in implied volatility would be beneficial to the strategy because then larger premiums could be attained along the way, but by using this conservative estimate to begin with, it fits well with the "worst case" scenario.

The first action to be taken is to sell 27 June 35 calls against the overall stock position, bringing in a credit of just under $2500. Our software estimates, based on current volatility levels, how many contracts should be sold initially, while still being able to "roll for a credit" at each subsequently higher striking price as the stock climbs toward the target. In other words, if the stock goes above the next higher strike (37.5 in this case, since striking price is 2.5 points apart in GE), action needs to be taken: buy back the calls that are currently sold and sell a larger number of contracts at the next higher strike. This "roll up" is done for even more or a credit. For example, suppose GE climbs to 37.5 next month. Then the 27 short June 35 calls would be bought back, and 34 September 37.5 calls sold in their place. The 34 Sept calls bring in a credit equal to the cost of buying back the 27 June calls, which would then be in-the-money. This process is repeated all the way up to 45 if GE continues to climb that high. Eventually, when it reaches 45, all 100 calls would be sold against the position – fully covering the 10,000 shares of GE stock. If the stock continues higher, it would then be called away (although there are some alternatives that can be taken – which will be described in a future article) and the stock owner would not only have realized the appreciation from the original price of 33 to the target price of 45, but he would also have kept any net credits generated along the way from written options.

In actual practice, a security rarely climbs in a linear fashion. If the worst case scenario does not develop – say the stock falls or goes sideways for a while – and the written options expire worthless, then options could be written at later expiration dates, generating even more credits.

The incremental return concept is an efficient and relatively conservative way to enhance returns on stock lingering in a trading range. Feel free to contact us if you have a stock holding that you would like analyzed.

This article was originally published in The Option Strategist Newsletter Volume 13, No. 3 on February 12, 2004.  

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