Portfolio Tactics: Analyzing Risk When Rolling Your Covered Calls
Question(s) of The Day
One of your fellow premium member, Sam S., struggled with the following question(s):
Hi Hamish,
First of all, I have been an OG premium member for a little less than a month, and have learnt a lot from the membership. Thank you for your time and your knowledge.
I have the following question: expiration Friday is looming and I'm not sure what strike prices to choose for rolling out and up. Can you give some guidance on what would make sense to moderate risk tolerance? Also, I want to lower my risk by selling an in-the-money covered call. What underlying should I utilize?
Kind regards,
Sam
These are very relevant questions, so let me break them down into 3 sub-questions: #1 what covered-call positions should we pay attention to? #2 how do we decide what strikes we're going to utilize for the new expiration cycle? #3 how we can lower our risk by selling 1-year in-the-money covered calls.
#1 Are We Utilizing Portfolio Overwriting or In-The-Money Covered-Call Writing?
Rolling out (and up) on/near expiration Friday only applies to short-term covered-call writing. However, it's possible that for a 1-year in-the-money covered call you can get assigned prior to expiration when there's an ex-dividend involved. As for Sam's question, we should focus on the short-term expiration cycle (July 17).
#2 How Do We Decide What Strikes To Utilize?
Initial Trades
When rolling out to a new expiration cycle, I'd like to discuss 2 of Sam's positions he currently has on.
Danaher: bought on June 19, 2020 at $174.90; sold the $180 July 17 call for $4.85
Veeva: bought on June 19, 2020 at $223.81; sold the $230 July 17 call for $10.13
Both stocks have since risen above the short call strike, but the difference between the two is huge: VEEVA is trading at $254.16, while Danaher is trading at $183.67.
Rolling Out Danaher Covered Calls
Evaluating the expected return for Danaher, the following screenshot of the elite calculator shows up.
(Source: Option Generator Calculator)
Excluding the upside potential, the return on our covered-call would stands at 2.77%. Our total breakeven, as can be seen from the image above, amounts to $170.05.
Now, let's evaluate the next one-month returns for $180 and $185 strikes in the AUG expiration cycle.
(Source: Option Generator's Calculators)
The current cost-to-close is $4.85 of which $3.67 is intrinsic value, leaving 29.42% of the option in time value. That component is going to disappear, so it pays for Sam to wait until next week to roll out to AUG. But let's say that we were to roll out right now. What would the AUG return be for the $180 (current strike) and the $185 strike? Time to figure that out.
As can be noticed from the image below, we pay $5.20 (mid-price of the July 17 options) to buy back the current short call. If we roll out to AUG, we're set to generate $10.6 for the $180 call and $6.90 for the $185 call. Without factoring in upside potential, rolling out would yield 3.00%, whereas rolling out and up would produce an additional one-month return of 2.98%. Moreover, since the $185 is slightly out-of-the-money we can generate an extra 0.72% in upside potential (from $183.67 to $185).
(Source: Option Generator's Calculators)
I've marked the word the net credit, meaning we're collecting additional cash in the rolling transactions. The following phrase should always be kept in mind: As long as we collect credits in rolling transactions, we continue to reduce our breakeven level.
In case of the $180 AUG call, our breakeven point will be reduced by another $5.40. Remember that our initial breakeven for the July expiration was standing at $170.05. Now it's $164.65. In case of holding the stock outright 100% (so without selling a covered call), we'd start losing money if DHR drops below $174.90... However, by choosing the $180 call, our shares are still theoretically worth $180 versus $183.70.
Talking about the $185 call, our shares will be worth $185 at the very maximum at expiration Friday in AUG. However, let me remind you that we also collect a net credit for rolling out and up! As such, our adjusted cost-basis is now $170.05 (initial situation) - $1.70 (net credit received when rolling out and up from $180 to $185) = $168.35 or roughly 2.7% higher than for rolling out.
Based on our overall portfolio delta (directional exposure to the underlings) and technical analysis, we make our final non-emotional rolling decision. As for DHR, the technical picture looks bright with an impressive streak of showing a positive directional movement index (DMI).
(Source: Pro Realtime)
Preliminary conclusion for DHR
Rolling out and up is a more bullish tactic, but in case of DHR, it still results in breakeven reduction. If we can achieve this every single month, our probability of profit will continue to march higher, thereby reducing the odds of facing a substantial and permanent capital loss. As highlighted in the article about Salesforce, covered-call writing on a monthly basis does not only lead to a higher win rate because of lowering the break-even point, it also reduces the standard deviation. Based on the chart technicals for DHR, I would favor rolling out to the $185 covered call if it fits within our risk tolerance boundaries. As there's still plenty of time value left in the current short call, waiting until expiration Friday makes sense.
Rolling Out Veeva Covered Calls
Let's now review the trade for VEEVA and our rolling possibilities.
Evaluating the expected return for VEEVA in the July cycle, the following screenshot of the elite calculator shows up.
(Source: Option Generator Calculator)
Excluding the upside potential, the return on our covered-call would stands at 4.53%. Our total breakeven, as can be seen from the image above, amounts to $213.68.
Now, let's evaluate the next one-month returns for $230, $240, $250 and $260 strikes in the AUG expiration cycle.
Rolling out (and up): $230 and $240 strike
(Source: Option Generator's Calculators)
The cost-to-close is $10.13, of which 2.58% is time value. There's nothing left to make on that July option. If we roll out to $230, we collect $29.80 for the AUG cycle; rolling out and up to $240 generates $22.70 for the AUG cycle. Summing it all up, we get the following outcomes.
(Source: Option Generator's Calculators)
By rolling out, we're collecting another credit resulting in $5 breakeven-reduction to $208.68. Our next one-month return for AUG stands at 2.17% as long as VEEVA's share price does not drop below $230. Rolling out and up to $240 unlocks upside potential that has so far been locked up in the $230 option. In essence, we free up $10 per share in upside potential by rolling up. Our forward 1-month return now equals to 3.43%. That's because the option is closer to current market value, resulting in more time value (theta).
However, there's a trade-off when rolling out and up for a debit: a higher breakeven-point, namely from $213.68 to $215.78. More importantly, our shares are now worth $240, not the current market value $254.16.
Rolling out (and up): $250 and $260 strike
Let's take it a step further and evaluate the returns for both the $250 and $260 AUG calls.
As for the $250 call, our new one-month return equals to 5.07% as long as share value does not fall below $250 by August expiration.
(Source: Option Generator's Calculators)
The $260 call allows for additional capital appreciation, but comes at a cost of $13.25 when rolling from July to August. A maximum profit potential of 7.04% can be reached if VEEVA trades above $260 by August expiration.
(Source: Option Generator's Calculators)
Let's visualize the total returns for these 4 strikes. The following numbers are valid as long as the share price does not fall below the strike price. For example, Sam's VEEVA position with a new $240 AUG call will have generated $24.22 by August 21, if and when VEEVA shares are trading above this strike price. That means that we have DOWNSIDE protection of that profit (5.5% correction from current market value).
(Source: Option Generator)
Preliminary conclusion for VEEV
By understanding how the numbers play out and where our real, adjusted cost-basis lies we can interpret risk much more efficiently. Given VEEVA's recent rally, a strike price of $240 or $250 is appropriate for moderately bullish or conservative investors. If we have 200 shares of VEEVA, we can sell one $240 AUG call and one $250 AUG call.
(Source: Pro Realtime)
Overall Conclusions on Monthly Covered-Call Writing
When selling monthly covered calls, we have to analyze our adjusted cost-basis, forward one-month returns and entire portfolio delta. We can roll out and up more aggressively if our risk tolerance allows us to do so, or if we put on defensive, non-correlated positions on.
In-The-Money Covered Call Writing
This was part 1 of Sam's e-mail. Let me now turn to CCI, a stock that's currently in his portfolio overwriting segment but can be transformed into a 1-year in-the-money covered call. Having written intensively on this topic, in-the-money covered call writing reduces the standard deviation, overall delta and correlation of our portfolio. In the real-life model portfolio that we share with our premium members, our overall delta looks as follows:
(Source: Option Generator)
As for in-the-money covered call writing, we're looking for the following:
A long-term leader on the premium watchlist report
A stock that has a decent overall rating, but not the best-in-class
Possibility of generating a 7+% annualized return
1-year expiration period (or between 9-12 months)
(Source: Option Generator's Calculators)
As always, we need to figure out what returns we can generate per unit of risk. It's the combination of putting various strategies together that make our methodology work in the long run. By answering questions from our fellow readers/premium members, we hope to provide the education needed to become financially independent.