Rockin' and Rollin' -- When to 'Roll Up' a Covered Call Position

Once a covered call position is established, one approach to managing that position is to simply “do nothing” until the expiration date. At expiration, one of two possible events occurs: (1) The stock price is above the option’s strike price (in-the-money) and the stock is ‘called away’ or ‘assigned’ (i.e. sold); or (2) the stock price is below the strike price, so the option ‘expires’ worthless and the stock position is retained. A ‘do nothing’ approach is often the best method for a covered call position and is normally an appropriate decision for the majority of covered call positions. However, there are some circumstances when it is preferable to manage (i.e. modify) the position before the expiration date. This modification is an opportunity to further enhance the potential return on investment that would otherwise be achieved by simply holding the initial position until expiration.

First, let’s make sure we have a common understanding of exactly what a roll up is. Paul Kadavy gives a nice explanation in his book ‘Covered Call Writing With ETFs’ where he describes the process of rolling up: “to buy back the first call options and then write new calls with a higher strike price.” I would add a short phrase at the end of that definition, namely ‘with the same expiration month’.

Before examining a specific example of a roll up, let’s mention some other examples of covered calls position management before expiration. This will help us to understand the the roll up within a broader context of the numerous position management (prior to expiration) alternatives. 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.”
An additional example would be ‘rolling up and out’, which would be the combination of simultaneously ‘rolling up’ and ‘rolling out’ -- for example, ‘rolling up and out’ from the XYZ Oct07 50s to the XYZ Nov07 55s. We will discuss these position management techniques in the future. For now, we will analyze only the rolling up case.

Let’s consider the Honeywell roll up done in the Covered Calls Advisor Portfolio as summarized in the previous post on this blog. In short, 500 shares of Honeywell (HON) were purchased on 9/10/07 at $54.23 and 5 Oct07 55 calls were sold at $1.80. When this covered call position was rolled up on 9/26/07, the stock had risen to $59.26 and the option to $4.70. Now the key question is: Should the existing position be kept until expiration or should it be rolled up to a higher strike price?

How should we analyze this decision? The key to understanding the answer is in the concept referred to as a ‘sunk cost’. A sunk cost is simply a cost that has already been incurred. It’s past. It’s history. So let’s consider our choices in the context of the HON example. First, disregard what happened between the time we initiated the covered call on 9/10/07 and today (we’ll pretend it’s now 9/26/07 for this example). The 68.5% annualized return achieved in the HON cc between 9/10 and 9/26 is now history; it’s a sunk cost (albeit a very profitable one). Nevertheless, what has already happened is meaningless in analyzing what we should do today (9/26) going forward.
Let’s compare two alternatives: (1) Do nothing. Keep the 500 HON shares and keep the 5 short Oct07 55s; or (2) Roll up. Keep the 500 HON shares and substitute 5 short Oct07 60 calls for the current 5 short Oct07 55 calls.
Here’s the key: Analyze the two option position alternatives as if you don’t already have a short options position.
Given that you already own 500 shares of HON at $59.26, would you prefer for the time period between now (9/26/07) and October expiration (10/20/07) to sell 5 Oct 55 options (priced at $4.70 on 9/26/07) or 5 Oct 60 options (priced at $1.10 on 9/26/07)? The primary factors for the two alternatives are as follows:
(1) For the Oct 55s:
Annualized Return If Unchanged (ARIU) = 11.3%
Annualized Return If Exercised (ARIE) = 11.3%
Downside Breakeven Protection = 7.9%
(2) For the Oct 60s:
Annualized Return If Unchanged (ARIU) = 28.2%
Annualized Return If Exercised (ARIE) = 47.2%
Downside Breakeven Protection = 1.9%
So which do you prefer? This advisor’s own personal guideline is to roll up to the higher strike price if two conditions are met: (1) The ARIU is more than 15% greater for the new position [in this case it was 16.9% higher (28.2%-11.3%)]; and (2) The per-day downside protection is >.06% [in this case it was .08% (1.9%/24 days until expiration)].
Your own criteria for an advantageous roll up might well be different than the 15% and .06% per day thresholds used by the Covered Calls Advisor.

Or perhaps your eyes are glazing over right now. You would really prefer an easier-to-apply guideline on when to roll up. If that is the case, I’d suggest using the ‘net debit to strike difference ratio’ as explained in the previous post on the HON roll up. There the guideline is: Roll up only if the ‘net debit to strike difference ratio’ is <75%. This analytical approach is definitely much less cumbersome than the more detailed approach described above, but it can be used with confidence since the resulting decision will be very comparable to that achieved by the more detailed method.

So, don’t be a ‘do nothing’. Start ‘Rockin and Rollin’ !!

Regards and Godspeed

Roll Up Adjustment -- Honeywell

The Covered Calls Advisor Portfolio (CCAP) covered call position in Honeywell(HON) was rolled up today (9/26/07) from the Oct 55s to the Oct 60s. A good-til-cancelled debit limit roll up order was placed at $3.60, and was executed as follows:

Buy-to-Close (BTC) 5 HON Oct 55s @ $4.70
Sell-to-Open (STO) 5 HON Oct 60s @ $1.10
Net Debit on Roll Up $3.60

The ‘net debit to strike price difference ratio’ was 72% [$3.60/($60-$55)], which meets this advisor’s threshold of rolling up only if the ratio is <75%.

A summary of the HON transactions so far is as follows:
Previously: Initial HON post
9/10/07 BTO 500 HON @ $54.23
9/10/07 STO 5 HON Oct 55s @$1.80
Today:
9/26/07 BTC 5 HON Oct 55s @ $4.70
9/26/07 STO 5 HON Oct 60s @ $1.10
Note: HON stock was trading at $59.26 today when the roll up transaction was executed.

The result for the completed Oct 55 covered call position and the status on the newly established Oct 60 covered call position (including commissions) are each summarized below:

(a) Completed Covered Call Position:
Original Stock Investment 9/10/07 – Purchased 500 shares @ $54.23 = ($27,124.95)
Change in Stock Value ($59.26-$54.23)*500 = $2,515.00
Change in Options Value ($913.70-$2,363.70) = -$1,450.00
Net Change ($2,515.00-$1,450.00) = $1,065.00
ANNUALIZED RETURN ON INVESTMENT:
(1,065.00/27,124.95)*(365/14 days) = 102.4%

(b) New Covered Call Position Established:
9/26/07 Retained 500 HON at $59.26 = ($29,630)
9/26/07 Sold 5 OCT07 60 Calls @ $1.10 = $564.95

Annualized Return If Unchanged (ARIU) 28.2%
Annualized Return If Exercised (ARIE) 47.2%
Downside Breakeven Protection 1.9%

Ten Factors to Consider when Analyzing a Potential Covered Call Investment

Too often we are prone to ask just two questions when we are analyzing a potential covered call (cc) position, namely:
1. Does it meet my minimum 'annualized return-on-investment %' threshold?
2. Does it provide adequate 'downside breakeven % protection'?

These questions are excellent to ask, but they should not be the sole factors considered when deciding whether or not to establish a particular covered call position.

For this advisor, the desired thresholds for these two factors are:
(1) >30% annualized return if the stock price is unchanged (ARIU) from its original purchase price; and
(2) >2.5% breakeven downside protection for near-month covered call positions.
Your own personal thresholds will likely differ from these, and that is fine; each investor will have his/her own risk tolerance level. Some investors are comfortable investing to achieve a somewhat lower return rate in order to obtain greater safety; while others seek higher returns and are willing to accept greater risk. That's all well and good. But regardless of your own personal risk/reward profile, it is essential that you consciously decide what your own risk level is; then, and only then, you should establish your personal thresholds for these two primary measures.

If we could only use two factors when analyzing potential covered call positions for investment, the two mentioned above would definitely be the ones to select. Fortunately however, there is no law that requires a limit of only two. These two should really serve only as the starting point in a total analysis of which specific covered call positions are worthy of a commitment of funds. Once it is determined that a particular cc option position meets the two basic thresholds, then this advisor suggests using eight additional factors to evaluate the relative value of a particular cc investment.

The eight additional factors considered by this covered calls advisor include:
1. Safety -- Downside protection is certainly one measure of safety, but there are others to consider. They include: days until expiration; days until next earnings release; the stock's historic volatility; dividend yield; financial liquidity as measured by the 'current ratio'; and financial leverage as measured by the 'debt/equity ratio'.
2. Profitability -- Two measures are determined here: free cash flow return on invested capital; and return on equity.
3. Stock Advisory Service's Ratings -- What is the overall rating of the company from the viewpoint of the two stock advisory services whose stock selection advice you prefer?
4. Value -- After the two primary factors (annualized ROI and breakeven downside protection), a particular company's valuation characteristics is the next most highly-weighted factor in this advisor's evaluation process. The measures used here include: volatility ratio (option's implied volatility divided by the stock's historic volatility); industry rating; price/earnings ratio; price/cash flow ratio; return on equity trend; and price/sales ratio.
5. Growth -- Three measures are used: price/earnings future growth rate; sustainable growth rate; and year-over-year cash flow per share growth.
6. Momentum -- Based on three measures of: stock price momentum; analysts' earnings estimates changes; and earnings surprises.
7. Management -- Currently uses the 'corporate governance quotients' both in comparison with its own industry and in comparison with all other companies.
8. Options Liquidity -- To ensure that there is adequate options liquidity to transact the option trades at a fair price. The option's 'open interest' as well as the bid/asked spreads are considered here.

Upon first reading, it is likely that these ten factors and all their related sub-factors will seem somewhat overwhelming. Well they are, at least for now. But over time, in-depth explanations of each of these items will be provided here. And as we are able to explore each of these factors more fully, their usefulness as an important part of developing and managing your own successful covered calls investing program will be demonstrated.
Looking forward to this journey with you.

Regards and Godspeed

Run With Nike

They say ‘sometimes it’s better to be lucky than good.’ That is certainly the case with my current Covered Calls Advisor Portfolio (CCAP) position in Nike.

After the market closed yesterday (Thursday), Nike announced 1st quarter ’08 earnings and they were awesome. Both top line (revenue) and bottom line (earnings) exceeded Wall Street expectations with revenue 11% above last year and earnings up 24%. Earnings were actually up by 51% when including a one-time tax benefit.

So why do I say ‘lucky’? Well, the truth of the matter is that I didn’t follow my own preferred method. I like to write near-month covered calls on companies that do not report earnings during that month -- I’ll explain the reasons why I prefer this method in detail in a post on this site at a later date. But for now suffice it to say that if I had focused on the fact that Nike was releasing their earnings prior to the Oct ’07 expiration date, then I would not have established the Nike position in the first place. So again, as they say: ‘Sometimes it’s better to be lucky than good.’

As I write this at Noon (Eastern Standard Time) on Friday, the market seems to have greeted this news in a positive, although somewhat muted way. The overall market, as measured by the Russell 3000, is up by .6% today while NKE is up 1.2% to $59.00. I’ll be considering the possibility of rolling up my Oct 55 call to either Oct 57.5 or Oct 60, but I will wait until Monday or Tuesday of next week to decide, which will allow a little more time for investors to more fully digest the earnings report and for the stock to reach a more normalized post-earnings level before deciding on the best action, if any, to take.

Further encouragement to us Nike investors was seen in the newly-presented objective stated by CEO Mark Parker on the conference call: ‘$23 billion in annual revenue by 2011’. From the $16.3 billion achieved in fiscal 2007, this would be a 9.0% compounded annual increase in revenues, which is consistent with, but also more specific than the previously stated objective of ‘high single-digit growth in revenue’. The increasing specificity by the CEO as well as the fact that he is willing to announce publicly a long-range target are both positive signs – first, in his confidence in the company’s ability to continue and accelerate their growth; and second, his willingness to set a long-range (2011) performance target. These types of actions by a CEO are very encouraging signs for us investors. Yet another encouraging sign was the recent blockbuster opening of Nike’s first store in Beijing, which initiates their China roll out plans. Also, the timing couldn’t be more fortuitous since we are now less than 1 year from the 2008 Summer Olympics in Beijing, a tremendous worldwide showcase for Nike footwear and apparel. It will take years for Nike to establish similar brand recognition and loyalty worldwide like they have established in the U.S.; but in this advisor’s opinion, chances are good that they will accomplish just that.

So, Run with Nike!