This Options Strategy Can Magnify Your Returns. Here’s How.

view original post

Traders at the Cboe’s new trading floor in Chicago.

Jim Vondruska/Getty Images

You can’t escape time or volatility. You must roll through them. This is more than a life philosophy—it’s part of the options market’s fabric.

Successfully curating stocks with options can add another source of returns to your portfolio, which is especially attractive in a year when stocks are under downward pressure. Rolling options over from one month to another before they expire—“rolls,” in market jargon—can enhance the strategy.

When an investor owns a stock and sells a call option, it’s called a covered call. The strategy may enhance returns, with the call’s premium providing a small buffer against the stock’s weakness.

Sellers of call options must sell the underlying stock if the stock price exceeds the call strike price at expiration. On June 17, for example, many calls that were sold against stocks expired worthless. The money received from those sales offset some of the weakness in the associated stocks.

The recent market swoon means many call sellers are keeping the premiums because so many stocks closed below the strike prices at expiration. That’s created interest in repeating the strategy. Many sellers likely wanted to reset those options before they expired, but they weren’t sure how to handle rolling calls. Here’s a reasonable framework for doing it.

When a short call’s profit hits 70% to 90% of the options premium, consider buying back the short call and selling another that expires in the next month. Some investors cover calls when they are worth 10 cents or less. Others focus on total profit. That’s up to you, but most professionals usually roll a profitable position rather than hold out for the final few pennies.

Many investors sell calls at about 10% above the stock price. The old rule calls for earning a premium of at least $1, but a better rule is earning a premium that compares favorably to the common stock dividend.

If everything works as expected, the money received for selling the call is kept and the investor essentially increases the stock’s yield. Don’t dismiss this. Dividends account for about 40% of historic stock returns, so boosting yields without major increases in risk is a big deal.

Sometimes things don’t go as planned. The risk to the covered-call strategy—and this is a major source of confusion and questions—is what to do when the stock price surges above the call strike price before expiration.

In-the-money calls—those with strike prices below the stock price—can usually be rolled for a credit to the same strike in the next month or two. (If not, it typically means the stock is paying its dividend before the next expiration.)

You may sometimes be able to roll to a higher strike price for a credit, but staying at the same strike price is OK, too. Many investors like rolling to the very next month, but some will roll two to three months out if it they can sell a strike that is higher than the stock price.

The main risk to rolling in-the-money calls is if the stock keeps rising rather than settling down. The stock could be called away by the buyer in what is called a “forced sale”—but often not. Most investors hate paying for a time premium, or the amount of an options price that reflects the time until expiration. This means it is often possible to roll calls to strikes that are lower than the stock price without being forced to sell stock. A crucial exception is when a stock is about to pay a dividend. In that case, holders of in-the-money calls often exercise calls to collect the dividend.

When all goes well, the use of simple, conservative options strategies can help you get paid to be a long-term investor.

Steven M. Sears is the president and chief operating officer of Options Solutions, a specialized asset-management firm. Neither he nor the firm has a position in the options or underlying securities mentioned in this column.

Email: editors@barrons.com