There was a lot of interest in our guest author Richard Melbourne’s post on managing ITM covered calls. As this seems to be a topic of interest, I will be looking to publish a few more articles on managing covered calls on this blog. To me, managing covered calls is more of an art than a science, and I use different management techniques depending on my expectations for the underlying stocks and why I wrote the calls in the first place.

I also received a request for more detail on rolling calls.  As the market has been very bullish, we have two ITM covered calls (on ANZ and STO) in our All Stars model portfolio which are expiring this month. We also had one ITM covered call (on XLK) which expired last month. Today I will walk through our options for managing these positions and provide the reasons for my preferred choice.

As Rich said in his article – there are basically two choices when your call is ITM, which are: either “roll up” (i.e. buy the ITM call back and to sell another call at a higher strike price with a longer expiry date) or allow yourself to be exercised and move onto the next position. Actually, there is a third choice, which is to simply buy your call back.

ANZ Feb $25 calls

We bought some ANZ shares at $25.51 per share and sold some Feb $25 calls on ANZ in Dec 2012 when the stock was trading at around $25. Since then the stock price has rallied to new highs and it is now trading at around $28.50. The first thing to do as suggested by Rich is to do a reconciliation of our ANZ position. By using the data filter function in our income tracker, it was very easy to “reconcile” our ANZ position as shown below (click to enlarge).

From the above, we can see that we will have a net profit of $1,442 if we do nothing and let our ANZ shares get called away at $25 when the call options expire on Feb 21st. This is roughly a 7% return on the capital I have tied up in this position over a period of less than 4 months. The purpose of selling the call was to help manage risk while collecting the dividends from ANZ. I am quite happy with this return, so I will let my shares get called away when the options expire. I have already set up a new position on ANZ for the next dividend cycle.

STO Feb $11.50 Calls

We were assigned some STO shares at $11.50 when our puts expired ITM in November 2012. We sold the Feb $11.50 calls in Dec 2012 and STO shares have since rallied up to $12.50. When we do the reconciliation for STO (see below), we can see that to date, we have received an income of $610 from selling options.

Our first choice is to let our shares get called away. This gives us roughly a 5% return on our capital in just under five months. Our second choice is to roll the options up, and we would only do this if we expect the share price to remain high in the next few months. Rolling options will cost us. We will have to take a realised loss in our options in exchange for a bigger unrealised gain in the stock.

From the prices in option chain above, it will cost us $0.34 ($1.135 to buy back the $11.50 call, less the $0.35 premium received and less the $0.445 premium we will receive from selling the Apr $12.50 call) to roll our Feb $11.50 calls up to April $12.50 calls. In return, we will get an unrealised gain of $1.00 (strike price of $12.50 – $11.50) in the shares and we will get to collect the March dividend. If we put all this into the income tracker, we can see the net income for the STO position if our shares get called away in April would be $1,110 which is roughly a 9.5% return in 7 months, an additional 4.5% for waiting another 2 months.

Of course, this is assuming the share price of STO is above $12.50 in April. If the share price falls, we will lose all the unrealised gains in the shares. This is why it is very important to have bullish expectations for the stock before deciding to roll our calls. If we are not sure, we would be better off to have our shares called away. We can always sell puts to get back into that stock at a better price later on.

When we look at the chart for STO (see below), there are a number of bullish technical signals. We can see that the share price has crossed above the 200 day MA and above the resistance level of $12. There is also a bullish crossover of the 50 and 200 MA.

As I expect the stock price to rise further, I am prepared to look at rolling my calls up in order to capture more capital gain in my shares. STO will also be paying a dividend in March so there is another reason for not wanting our shares to be called away in February. However, STO has yet to announce their earnings and dividends. If the earnings are bad, the dividends may be less than expected and the share price could take a tumble and wipe out any unrealised capital gains in our shares. My preference normally is not to roll my calls as there is the least risk in taking this option. However, for educational purposes, I have rolled our STO Feb $11.50 calls up in our All Stars model portfolio.

XLK Jan $29 calls

I briefly mentioned earlier that there is a third option for managing ITM calls, which is simply to buy the ITM call back. In Nov 2012, we sold some Jan $29 calls at what I thought was a very strong resistance level. However, the share price was able to break above this level in early January, and even retested it successfully as shown in the chart below. Hence, I had pretty bullish expectations for XLK in the next few months. 

On Jan 18, one day before January options expiry, my ITM option was trading below the price I sold it for (thanks to the magic of time decay), so I could buy it back without incurring a loss. I simply bought the option back and waited a few weeks for the share price to rise before selling another call at a higher strike price. The transactions are shown in the income tracker below.

I hope walking through the three examples above gives you a better idea for working out whether to roll an ITM call or not. You can download a complimentary copy of the income tracker from the Resources page of our website to help you reconcile your positions quickly.

Many stock investors who sell covered calls feel they have to roll their calls as they do not want to lose their stocks or miss out on dividend payments and capital gains in the stock. As I mentioned in my training videos, you will need a change of mind set when you start selling covered calls. Selling a covered call is equivalent to making an offer to sell your stocks at a certain price. If you are not happy to sell at that price, perhaps you should not be selling calls at that strike price. I usually do my reconciliation BEFORE I sell my calls and work out my profit/loss should my shares get called away. I seldom roll the calls in my income portfolio as I am normally quite happy for my shares to get called away and move on to my next trade.

The objective of our income strategy is to get consistent income in all market conditions and this could mean missing out on some capital gains in your shares when there is a bullish run. Remember shares can go up, down or stay sideways. With covered calls, we always get to keep our call premium regardless of what happens with the stock so our probability for making money is higher than just holding the stock.

If you do not want your shares to be called away, you may want to consider managing your covered calls using the Delta Strategy. This is a mechanical management strategy, where calls are rolled based on the delta of the option. I will discuss this in more detail in Part 3 of managing ITM Covered Calls so stay tuned!

Disclaimer: This post is for educational purposes only and should not be treated as investment advice. This strategy would not be suitable for stock investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek investment advice if required.

2 Responses to Managing ITM covered calls Part 2 – To roll or not to roll?

  1. Jim says:

    Very interesting article on managing ITM calls. I used a “roll up” strategy on some WOW short puts, as the put I sold lost most of their value in a week due to the rising share price. So I then closed the short put position at a profit, and opened another short put at a higher strike. The new puts still didn’t get assigned so I ended up just keeping both premiums.

    • Christina says:

      Hi Jim,
      It is a good idea to close a short put when you have got most of the profit. Selling the next higher priced put is fine if you are still happy to buy the stock at the higher price should the share price fall and your puts get assigned. With stocks like WOW which have risen dramatically, a bull put spread i.e. having a long put at a lower strike price might be a safer trade.

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