Finance Roll

Last week we investigated Covered Calls, a strategy whereby we write Call Options against shares we own in order to increase our return from owning the shares and to provide some downside protection should the share price fall.

Once we write a covered call, three things can happen;

1. The share price can rise in value;

2. The share price can stay the same; or

3. The share price can fall.

Let's consider the alternatives and assume the share price rises. As with all option strategies, the alternatives exist to do nothing. In such an instance our option would be in-the-money (ITM), our option would be exercised and our stock sold.

Our profit from such an occurrence would then compromise the initial premium we received from writing the call plus the profit from the sale of our shares. Whilst we would have made a profit on the transaction we would no longer own our shares.

This brings us to a very important consideration: you must only write options against shares you are willing to sell. If you have pre-capital gains tax stock which has inherent tax advantages to it, you should NOT write options against it unless you are willing to sell it.

Instead of having our stock called away, we have a second alternative. Suppose the share price has risen very high. If we covered or bought back the option we would lose money, as the value of the option would now be greater than the premium we originally received for it. However, we have removed our obligation to sell our shares at a lower price than where the share is now. So in reality whilst it has cost us money to buy our option back, we have a larger unrealised gain on the shares due to the steep appreciation in the share price.

In addition, by closing out our option (buying it back) we are now free to write another option at a higher strike price - thereby increasing our potential profit.

Such a tactic is known as Rolling Up.

Often, the extra premium generated from the second call we write is enough to cover the loss incurred from buying the first option back, thereby putting us back in a profit position.

Also, this profit is identical to the one we would have made if our stock had been called away. The major difference between these two alternatives is that we no longer own the stock after being exercised - whereas we retain ownership if we buy our option back. It is not always immediately apparent which of the two alternatives is best in any given situation.

If the share price stays the same, then the option will expire worthless. We retain our shares and get to keep the premium. We can typically make between 2-7% of the value of the shares on a monthly basis. Annualised, that's a return of 20-60% per annum! But what if the share price falls?

Defensive Action

Suppose we own Telstra (TLS) shares that we purchased at $7.70 and when TLS was trading at $8.20 we sold TLS July calls for $0.30 premium. We now have a $0.30 downside protection. Let's now assume that TLS falls heavily and is trading at $7.30 - we have an unrealised loss of $0.40 on our stock. What action can we take to enhance our position?

As our stock falls so too does our option. The first step is the buy the option back thereby locking in our premium. Secondly, we must look for another option with a lower strike price and/or later expiry date.

This tactic is known as Rolling Down.

Suppose in our example we let the option expire worthless and sell a TLS July 750 call at $0.30. This would provide us with an additional $0.30 downside protection.

Hence our downside breakeven has been lowered from $7.40 to $7.10. So, rolling down has simultaneously given us further protection and increased our income if the stock stabilises.