Friday, November 6, 2009

Covered Calls Position Management -- When to Roll

Does covered calls investing have any inherent advantages over a basic buy-and-hold strategy? That is, whenever we analyze our own investing methods, it is important to try to identify advantages that our own methods might have when compared with other approaches. The Covered Calls Advisor's term for this thought process is identifying our 'investable edges'.

Do covered calls provide us with any investable edges? This advisor has observed that many covered calls investors have transitioned to covered calls after having been primarily a stock market buy-and-hold type of investor. This evolution is a natural one because when compared with buy-and-hold, covered calls have an edge for investors who seek to reduce risk while still retaining an opportunity to obtain a competitive overall rate of return. This 'investable edge' is achieved primarily from the immediate options income cash flow that is received each time call options are sold when establishing a covered calls position.

Compared with buy-and-hold, are there any other 'investable edges' that the covered calls investor has? This advisor says "Yes".
Another 'edge' is available from disciplined covered calls position management. The 'investable edge' provided by this active position management can be exploited by the process of 'rolling' an existing covered calls position at an opportune time -- but just when is an opportune time for rolling an existing covered calls position to a new covered calls position? This is the question addressed in the remainder of this article.

First, for the sake of clarity, let's briefly define terms. What exactly is meant by 'rolling' a covered calls position?
On page 70 of ‘New Insights on Covered Call Writing’ by Lehman and McMillan, they succinctly define the relevant terms:
“Rolling: The process of closing the short call position in a covered write and opening (substituting) a different covered call position on the same stock.
Rolling Up: Substituting a call with a higher strike price.
Rolling Down: Substituting a call with a lower strike price.
Rolling Out: Substituting a call with a more distant expiration.”
‘Rolling Up and Out’ would be the combination of simultaneously ‘rolling up’ and ‘rolling out’ -- for example, ‘rolling up and out’ from the XYZ Nov2009 $50s to the XYZ Dec2009 $55s.

Now, the crucial question: When should we 'roll'? This is one of the most popular topics raised by members of the 'justcoveredcalls' Yahoo Group site. Yet despite the numerous occasions that this topic has been broached and the numerous responses posted, this question continues to frequently re-appear -- it just keeps coming back! Why?
I believe it is because it is difficult to develop a set of relatively easy-to-apply decision-making rules for this relatively complex question.
My own thinking on this question is a testimony to this difficulty. In the short two year history of this blog, this will be the Covered Calls Advisor's third post that attempts to specify a workable approach to 'rolling'. Both my first (link#1) and second (link#2) articles on this topic were reasonably solid approaches to aid our decision-making process concerning when to roll an existing covered calls position. But the specific criteria developed were too cumbersome to be followed easily and consistently.

During the past six months, the Covered Calls Advisor has been testing numerous covered calls positions with the objective of developing a set of criteria for rolling that would have the dual benefit of:
(1) achieving net incremental returns in comparison with simply always holding our existing positions until expiration; and
(2) being reasonably easy to apply.
The criteria described below are the result of this effort and are as close as the Covered Calls Advisor can currently come to achieving both objectives.

The guidelines that will now be used by this Covered Calls Advisor to determine when and how to 'roll' any existing covered calls position are as follows:
1. Roll up(down) when the current equity price is more than 10% above(below) the current strike price; and
2. Make the roll transactions when the current equity price is very close to the new strike price (within + or - $.25 of the new strike price) -- i.e. very close to at-the-money; and
3. Roll (within the same expiration month) if more than 1 week (7 calendar days) until expiration. Roll out to the next expiration month if 1 week or less from the current expiration.

In the interest of brevity and simplicity, a detailed explanation of why each of these three guidelines are what they are will not be presented at this time. For now, suffice it to say that when initially establishing a new covered calls position, this advisor advocates establishing positions with short-term (i.e. nearest-month) expirations. Consequently, in a practical sense, the relatively large 10% price change threshold required in #1 above is likely to result in relatively infrequent rolling transactions.

If you have any comments or questions on this article or on any of the three criteria presented, please feel free to submit them by clicking on the 'comments' link below. If you prefer confidential communications, my email address is listed at the top-right sidebar of this blog site. Your comments are always welcomed.

Regards and Godspeed,