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Rolling Out Decisions: Evaluating a Real Life Trade
08/04/2015 8:00 am EST
Alan Ellman, of TheBlueCollarInvestor.com, follows up his recent article evaluating a trade where an option was rolled up in the same contract month by analyzing another. However, this time, while the two-month results were positive, Alan questions if they could have been better.
Rolling options is an important exit strategy choice when selling covered call and put options. Options can be rolled up and down in the same contract month or a future contract month. For the most part, we roll down in the same contract month and roll out or out-and-up in the next contract month. I recently wrote an article evaluating a trade executed by one of our members where an option was rolled up in the same contract month, an approach I rarely subscribe to. In this article, we will evaluate another real-life trade by one of our members (we have a great group) where an option was rolled out. The two-month results were positive, but could they have been better?
The initial trade with VRX: Month 1:
- 5/26/2015: Buy 100 VRX at $234.60
- 5/26/2015: Sell 1 x June $240.00 call at $4.50
- 6/17/15: Early on expiration Friday the stock was still trading near $234.60
Let’s feed this preliminary information into the multiple tab of the Ellman Calculator:
We see a respectable 1.9% initial return with the possibility of an additional 2.3% from share appreciation. Because share price remained stagnant, the actual one-month return was 1.9% or 23% annualized. Very nice so far.
The second trade with VRX: Month 2:
The option was rolled out to the next month $240 strike. This involved closing the June $240.00 contract (BTC) and opening the July $240.00 contract (STO). The option credit for these trades netted $0.20. Then, mid-contract, the option was rolled down to the $235.00 strike. Here are the trades in month 2:
- 6/17/2015: Rollout to the July $240.00 strike for a net credit of $20.00 for the contract
- 7/8/2015: BTC (buy-to-close) the July $240.00 call at $2.35
- 7/9/2015: STO (sell-to-open) the July $235.00 call at $4.50
- 7/17/2015: VRX was trading at $240.00 level and shares were sold at $235.00
Calculating 2-month returns
The shares were purchased at $234.60 and sold for $235.00, a net credit of $40.00 for the 100 shares (less small trading commissions). There were option credits of $450.00 + $20.00 (includes rolling option debit) + $450.00 = $920.00. There was an option debit of $235.00. The net option credit was $685.00. The total position credit was $685.00 + $40.00 = $725.00 which calculates to a 2-month return of 3.1% on a cost basis of $23,460.00. This annualizes to 18.5%. On the surface, this looks pretty good, especially when we compare it to other investment choices we have these days.
NEXT PAGE: Could the Trade Have Been Improved?|pagebreak|
As Blue Collar Investors, we are always looking for ways to elevate our returns—even good ones—to higher levels. A 3.1% 2-month return appears reasonable on the surface but of that total, 1.9% was generated in month 1. The remaining 1% was generated in month 2, so therein lies the weakness of this 2-month trade. It seems that the option from month 1 was rolled when there was no need to do so. The share price was much less than the strike ($240.00) and so allowing the option to expire worthless was the prudent thing to do (take no action). That would eliminate any time value spent to close the near-month option plus eliminate one commission. Since the shares would not be sold, the next month option could be sold on Monday. Let’s make the reasonable assumption that the time value remaining on the near month option was $0.10 and so the next month $240.00 strike sold for $0.30, leaving a net credit of $0.20. Even if the option wasn’t rolled, the initial return of the next month option ($0.30 is our educated assumption) only generated 0.12% initial profit, far too little.
How to improve this 2-month trade
- First, don’t roll the option
- Sell a lower strike if VRX was still maintained as an underlying security, probably the $235.00 strike, which was used late in the contract
- Using the $235.00 strike would have generated a significantly higher time value return, especially if it was used early in the contract. It is reasonable to assume the return would be greater than the $4.50 originally generated in the near month trade (which had a higher strike of $240.00).
- If the calculations for VRX did not meet our goals, sell the stock and use a different security
Exit strategies like rolling options are absolutely critical to maximizing covered call returns. There are times when these strategies should and should not be used. Setting goals for initial monthly returns is one way we are guided to proper decisions. For example, if a trader sets a goals range for monthly returns of 2-4% as I do, a rolling return of 0.12% would never be given consideration. That said, the trade was an overall success and I commend our member for the way it was managed. Now let’s take that 18% annualized return and bump it up even higher.
By Alan Ellman of TheBlueCollarInvestor.com