Reassuring comments from Fed Chair Janet Yellen helped propel stocks into the stratosphere yesterday. As if they needed help. Poor bears are being roasted and toasted. The market melt-up is delivering some serious anxiety to covered call lovers. The anxiety is that of the regret variety. The kind that arrives after you’ve made a good decision and suddenly realize there was a better option.
Of what do I speak?
Why, the profit limiting baggage that comes with covered call selling, of course. The feeling that comes when you capped your reward at a 4% return for the month only to see your beloved stock rip higher 10%.
Months like these make you feel like a shmuck if you’re not careful.
Personally, I set myself up psychologically so that if I capture my max reward I’m tickled pink. I always run the numbers at the outset of the covered call to ensure the potential profit is adequate. Say it’s 4% for the month. Well, that’s 48% annualized so who cares if the stock rips 10%? It sure as heck isn’t going to do that every month and eventually the wisdom of selling calls will be made manifest.
But suppose you’re still not happy. Might there be an adjustment you can make to open up the floodgates and let the profits roll forth? A way to uncap the profit spigot so it can flow unimpeded? But of course. Though it’s not without its disadvantages. The adjustment we’re getting to is referred to as rolling up.
Allow me to set the stage. Suppose you own 100 shares of QQQ and earlier this month you sold the April 108 call option for $1. Remember, by selling the call you obligate yourself to sell your stock at $108. At the time QQQ was worth about $105 which means your profit on the stock was limited to $3 plus the $1 premium. So $4 total which is about 4% for the month.
Now, with QQQ closing in on $110 and 3 weeks remaining until expiration you’re feeling like a dunce for having capped your profit at $108. Before discussing rolling, let’s make sure we understand the pro and con of staying pat.
The con is easy. You can’t make any more money on the stock if it rips higher over the next few weeks. The only remaining profit is whatever time value is still embedded in your short 108 call. But so what? You knew that going into the trade, no?
The pros are often overlooked. Really it’s just one. You have a boatload of protection with your short call now resting ITM. With QQQ at $110 the April 108 call boasts $2.75 of premium. That’s enough to offset almost a 3% drawdown in QQQ over the coming weeks. It’s easy to kick back and relax during a downturn when you’re sitting on that much protection.
I suppose another advantage is that if QQQ does drop back you’ll be able to buyback your call lower than $2.75 thereby locking in less of a loss.
If you want to uncap some of that upside potential, however, you could roll up. Buyback the April 108 call and sell the April 110 or 111 call. Of course, you could also roll up and out. But that’s a tale for another time.
On a positive note you will now be able to capture additional profits in the stock up to the new strike price. In addition because the new call strike is closer to the money it probably has more time value affording more potential profit between now and expiration.
Here’s the negative. Let’s say you buyback the April 108 call now at $2.75 and sell the April 111 call for 80 cents. Sure, you can bask in the knowledge that you’ve opened up the possibility for additional gains in the stock, but what if QQQ drops over the next couple of weeks? You’re only sitting on 80 cents protection instead of $2.75. And knowing your luck you’ll buyback the April 108 call right as QQQ is peaking which is the absolute worst time to do it.
Just some food for thought for you covered call sellers.
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