Covered call writers can avoid exercise by closing the call and replacing it with a later-expiring one. But some pitfalls may also occur along the way.
The forward roll works because a later-expiring contract is always worth more, due to higher time value. You can always change out the short position profitably.
You can roll forward to a later option with the same strike or even to one a strike higher, in which case it is more difficult to create a net credit. However, if you are exchanging the current strike for one five points higher and you lose $200 on the deal, what happens if the later strike is exercised? You make a profit:
Extra profit on exercise $500
Less: loss on the forward roll -200
Net profit $300
The system of replacing calls is simple. However, there are four major pitfalls with the forward roll of a short call. Before proceeding with this tactic, be aware of the hidden dangers. These are:
- It doesn’t always avoid exercise. If the ultimate goal is to avoid exercise, the forward roll is not always successful. For example, if an ex-dividend date occurs before the later call’s expiration, the short call might be exercised right before ex-date, a strategy used to get the dividend in addition to a profit in the 100 shares. Be aware of ex-dates when you roll forward and remember that exercise can happen at any time. The period immediately before ex-dividend is the most likely time for early exercise of in-the-money short calls.
- It might not be worth the delay. If your roll produces less than a net of $50 or so, you have to question whether it is worth it to tie up your position for another month. In some cases, letting exercise happen and getting your 100 shares called away is the most sensible outcome. Compare likely outcomes and remember to compare profitability and the time required to keep your shares covered, the exposure itself, and the collateral requirements.
- If you don’t run the numbers, you could lose on increasing the strike. Make sure you create a profitable situation when you move up one strike as part of your forward roll. For example, if your strike goes up 2 1/2 points but you lose $275 on the net change in value on the deal, you lose money. Just performing some basic math avoids the error occurring from making an assumption without checking the net effect of the roll.
- You could create an unqualified covered call. The forward roll can unintentionally set you up with an unqualified covered call. If you are close to getting to long-term capital gains status on your shares of stock, but your roll creates a new position with a strike more than an increment below current market value, the period counting toward favorable long-term treatment stops dead. Investigate the rules for qualified and unqualified covered calls and make sure you don’t lose the better tax rate in the deal.
Covered call forward rolling is a sensible strategy, but you have to know all of the likely pitfalls so that you have a realistic grasp of what can happen. You want to make sure you know what to expect. Remember, experience is what you get when you were expecting something else.