4 Pitfalls of the Forward Roll

03/03/2015 8:00 am EST

Focus: OPTIONS

Michael Thomsett

Founder, Thomsett Publishing Website

This is a popular strategy used by traders who want to keep the underlying stock while generating additional income, but there are drawbacks as well, writes Michael Thomsett of ThomsettOptions.com.

Traders, especially covered call writers, love the forward roll. It helps avoid or defer exercise, creates additional income, and helps keep ownership of stock that is on an uptrend. But there are potential problems. Among these are the following four every covered call writer needs to remember:

  1. Rolling keeps you exposed longer, tying up capital. As advantageous as it might look to roll forward, does it really make sense? When you roll, you buy to close the original position and replace it with a sell to open, later-expiring new position. But this means you keep yourself exposed to exercise risk and tied up on margin for the extended period of time. The question becomes: Does rolling make sense? Sometimes it does and sometimes it does not.
  1. Unless you roll to the same or a higher strike, you could end up losing. Some traders, intent on avoiding exercise, roll to a lower strike. This is a big mistake. The lower strike means you get a lower capital gain when the call is exercised. So you have to hope for a decline in the stock's value in order for the call to work. But this means the profit in the call-if it materializes-will be offset by a smaller capital gain (or a loss) in the underlying upon exercise.
  1. It makes more sense at times to take a small loss or even accept exercise. Given how close the outcomes are in many rolling instances, and also thinking about the risk coming from extra time exposed, you might be better off buying to close at a loss and waiting out a better covered call situation. You could also keep the position open and accept exercise. If you picked the call wisely and created a capital gain and option premium profits, exercise is not a bad outcome.
  1. You could end up with unintended tax consequences. The tax rules for options are among the oddest of all. One rule is involved with what are called "unqualified" covered calls. Under this rule, if you sell a covered call deep in-the-money (usually meaning one increment or more below current strike), you could have the period leading up to long-term treatment of the underlying tolled, meaning the count is stopped as long as the short call is open. For example, if you own stock for nine months at the time you open a covered call, and you then roll to a later call, you could lose your long-term capital gain on the stock. This applies only if the call is unqualified, and if it is exercised after the one-year period has passed. The period counted only goes up to the point where you opened the new call. So you could open a qualified position; but then the stock moves up, so you roll forward to the same strike and a later expiration. This move is treated as two separate transactions, and the later one, now deep in the money, could be unqualified.

Forward rolling is never guaranteed to work, and in some cases, might even result in unintended tax consequences-or worse-magnify a loss. So, make sure you know all the nitty gritty of this advanced strategy before you implement it to avoid any unpleasant surprises.

By Michael Thomsett of ThomsettOptions.com

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