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Covered Call Exit Strategies

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As covered call investors, we generally want the stocks on which we are trading covered calls to be neutral to slightly higher when expiration date approaches.

If the stock rises too much, we have foregone potential profit by selling the call, and if the stock falls too far we are left with an unrealized loss on our stock position.

In a perfect world, the stock would finish up just below our call strike on expiration day. Unfortunately, the world is not perfect, particularly when it comes to financial markets.

Covered Call Exit Strategies

In most cases, investors will need to take some sort of action on or around the expiration date and sometimes even earlier than that.

Managing the exit side of a covered call is far harder than the entry side and should be decided in advance of entering the trade. This should all be written down as part of your trading plan.

There are generally considered to be seven different actions you can take with regards to exiting a covered call trade:

  • Let the call expire
  • Let the call be assigned and have the stock be called away
  • Close out the call and retain the stock
  • Unwind the entire position by selling the stock and simultaneously buying back the call
  • Rollout the call to the next month at the same strike price
  • Rollout to the next month and move the strike up
  • Rollout to the next month and move the strike down

Let’s look at each of these scenarios in detail.

Let The Call Expire

As expiration approaches, if the stock has remained flat or declined slightly, investors can simply let the calls expire worthless.

The premium they received for selling the call is theirs to keep and the obligation they had from selling the call (to deliver shares at the strike price if called upon to do so) is removed from their account.

This of course assumes that the stock has not declined below your stop loss level. If you had a stop loss of 8% and the stock is down 8% as expiry approaches, you may be better off to unwind the entire position.

If the stock has not reached your stop loss level and you are still neutral to slightly bullish, then you can sell another call option if you so desire.

If the investors outlook has changed to strongly bullish, then they may choose to simply continue to hold the stock without selling calls with the aim of achieving higher capital returns.

Occasionally, when expiration draws nearer, the stock can be trading right around the strike price. In this case, it is difficult to know if the stock will finish in-the-money or out-of-the-money.

Remember that even if the call expires in-the-money by as little as $0.01, it will be automatically assigned. In the scenario where the stock is trading right around the strike price, one of the other six actions may be more appropriate than hoping the call will finish out-of-the-money.

Let The Call Be Assigned

At expiry, if the call option is in-the-money by as little as $0.01, the buyer of the call will exercise their right to purchase the shares at the strike price and your shares will be called away.

Generally speaking, this is a good thing. Assuming you have sold at-the-money, or slightly out-of-the money calls, you will be in a position of profit. In fact, with covered calls, this is the maximum profit that can be achieved.

When you are assigned, both the stock and call option will be removed from your account. The net credit will be deposited into your account which will be equal to the number of shares x the strike price.

Remember that you also still keep the option premium that you initially received when selling the call.

Sometimes option assignments will occur prior to expiration. This is most common on dividend paying stocks, although it can happen on any stock. Usually early assignment occurs on the day before the stock goes ex-dividend. The call buyer exercises their option early in order to take ownership of the stock on ex-dividend day and therefore receive the dividend.

This commonly occurs when the call option is in-the-money and the dividend amount exceeds the remaining time premium on the option.

In this case, the call buyer is better off to exercise their option and receive the dividend rather than waiting for the time premium to decay (which is less than the dividend in any case). When the call buyer exercises their option early, any remaining time value is lost.

Traders that plan to sell covered calls on dividend paying stocks should be aware of how early assignment works, why it would occur and they should also keep a close eye on the ex-dividend dates.

Close Out The Call And Retain The Stock

Investors who have a covered call position that is in-the-money near expiry, but want to retain ownership of the stock, should close out the call option prior to expiry.

To do this, the investor makes the opposite trade to when they opened the covered call.

The opening trade would have involved selling the call option, so the investor simply places a buy to close order.

That information probably seems basic to you, but you would be surprised how many times I get asked this question.

After buying back the call, the investor has removed the obligation to deliver the shares at the strike price and can continue to hold the shares.

Investors might close out the call option and retain the stock if they want to continue to receive the dividends from the stock and / or continue to participate in any future capital gains.

Choosing to retain the stock, generally implies that the investor is still bullish on the stocks prospects.

Unwind The Entire Position

Unwinding both parts of a covered call position (long stock and short call), can be a prudent choice if the stock has experience a large gain early on in the trade.

In this case, unwinding the trade will lock in the gain, although this will be less than the maximum potential gain if the position was held to expiry. Sometimes it is best to lock in a gain rather than see the position fall back down and potentially become a losing position.

Call options have a delta, which can provide a guide as to how much the option price will change compared to the change in the stock price.

For example, if an investor buys a stock at $25 and sells a $25 call, the call option will have a delta of 0.50 meaning it will increase 50c for every $1 move in the stock.

Assuming the call option was sold for $2 and after 3 days, the stock has increased to $26, the call option will now be worth approximately $2.50. This is a very simplified calculation and in reality there are a few other factors that will affect the option price such as implied volatility, time decay and gamma.

In the above example, the investor will be sitting on a gain of 50c.  A $1 gain from the stock price increase and a 50c loss from the call option increase (remember we sold the call).

The total potential profit on the trade is $2 and the investor has made 50c or 25% of the potential profit after 3 days. In this case, the investor may be tempted to unwind the position and book a profit rather than wait until expiry to hopefully receive the other $1.50 in profit.

There is a good rule of thumb that can be followed when considering unwinding a covered call early:

Covered Call Exit Strategies 2

If this formula results in a number greater than one, it can make sense to unwind the trade.

Taking the example above, if this was a 30-day trade, the formula would be:

0.25 / 0.10 = 2.5

As this is greater than 1, it makes sense to unwind the trade.  25 percent of the profit has been made in 10 percent of the trade duration.

The investor would have to wait through 90% of the remaining trade time to achieve the remaining 75% profit potential.

There is also the potential that the stock could fall back down and the investor could give back some of the profit.

This is just a rule of thumb and its really personal preference, but it is something that should be detailed in a trading plan.

For example, an investor may choose to modify the rule slightly and say that they will unwind the position if the above formula is greater than 1 AND the profit is greater than 50% of the potential profit.

Rollout

Rolling out refers to the process of closing the short call and selling a new call with the same strike in a subsequent month at the same strike price.

Investors would look to do this if the stock is close to the strike price as expiration approaches and they believe the downside is minimal. i.e. they continue to maintain a neutral to slightly bullish outlook.

If the investor wants to maintain exposure to the stock but is concerned they might be assigned, then a rollout is a good idea.

The process of rolling out will almost always result in a net credit if the options are at-the-money or close to it.

For example, the near month option which is being bought to close might be trading at $1 and the next month option which is being sold to open might be trading at $2.

By closing the near month and opening the later month, the trader receives a net credit of $1 while still maintaining the same covered call exposure.

The difference in option premiums may be much less for deep in-the-money or out-of-the-money calls due to the low time premium component. Rolling out these types of positions may not make sense given the small additional premium received.

As such, rolling out covered calls tends to make the most sense near expiry, when the stock is close to the strike price.

Rolling Out And Up

Another possibility when expiration is approaching and the stock is close to the strike price is to roll out and up. Usually an investor would only do this if they are bullish on the stock.

In order to roll up, the investor would close the current month call through buying it back and selling the future month higher strike calls.

Sometimes, investors may be able to roll out and up for a net credit, but this adjustment can also require a net debit.

For example, let’s assume that as the April expiry date approaches, the stock is trading at $24.50 and the $25 call is trading for $2.00.  An investor is bullish on the stock and wants to maintain exposure, but thinks the stock has the potential to rise to the $27-28 level.

The May $27.50 call is trading at $1.20.

If the investor rolls out 1 month and up to $27.50, the adjustment will result in a net debit of $0.80 because they are buying back the $25 call for $2 and selling the $27.50 call for $1.20.

However, there is an extra profit potential in the trade, given that the stock will not be assigned until $27.50, so there is an additional potential capital appreciation component of $2.50.

As this adjustment example costs money to implement, investors would generally only consider this method when they are bullish.

Rolling Out And Down

A roll out and down might be considered as a way to lock in some profits on a stock that has risen above the strike price.

Looking at SPY which is currently trading at 203.22. Assume a trader has sold an April covered call using the $200 strike.

The call is now in-the-money to the tune of $3.22 and has a time premium component of $1.35 for a total premium of $4.57.

By rolling out to May and down to $195, you generate $5.87 in premium and give up $5 of intrinsic value.

In other words, you gain an extra $87 by waiting another month and are protected down to $195 rather than only $200.

SPY covered call roll down example

SPY covered call roll down example part 2

Closing Early To Avoid Earnings Volatility

One final reason for closing covered calls early, is to avoid volatility surrounding earnings announcements. Depending on the stock, it is not uncommon to see a move of 5%, 10% even 20% after an earnings announcement.

A 20% gap down is a covered call writer’s nightmare.  The sold call does little to protect the downside move and a gap down of 20% would blow right through any stop loss.

Sometimes, it can be best to avoid these earnings announcements particularly if a big move is anticipated. Investors should always check a company’s earnings date before entering a covered call trade.

It might be best to remove high volatility stocks from an investors covered call candidate list altogether, or if an investor does decide to go with these types of stocks, they need to understand the risks they are exposing themselves to.

In Summary

  • Covered calls can be a great way to gain additional income for a stock
  • Entering a covered call is the easy part. Managing what happens next is the hard part.
  • The are 7 main ways to exit a covered call trade
    • Let them expire
    • Let them be assigned
    • Close the call and keep the stock
    • Close the entire position
    • Roll out
    • Roll out and up
    • Roll out and down

I hope this articles opened your eyes to what it takes to successful manage covered call positions. Let me know what you think about this article in the comment section below.

26 Comments
  1. Len Petry says:

    Good explanation, as usual, Gavin.

    Len

    1. Gavin says:

      Thanks Len. Hope all is well with you.

  2. Brian Shepherd says:

    In the “Rolling Out and Down” example; how exactly do you come up with $5.87 premium figure? Also, where exactly does the $87 come from? Thank You!

    1. Gavin says:

      Hi Brian,

      When I wrote the article, the May $195 call was trading at $10.44. Buying back the $200 call for $4.57 and selling the new call for $10.44 gives us a net premium of $5.87 received.

      We are giving up $5 of capital by lowering the strike price. So $5.87 less $5 = $0.87 or $87.

      Hope that helps. Let me know if you still have questions.

  3. David says:

    thank you Gavin
    appreciate your time and willingness to share your experience and time.
    your posting could not have been more timely,after reading it,went to my open positions and closed 2 expiring this week,was able to minimize loss and secure small profit on a covered call that was almost sure will have been assigned,most important gave me a more structured way to look at my choices.
    Excellent,like how clearly you present your ideas,same applies to your book on Condor that I purchased for my Kindle.
    David

    1. Gavin says:

      Hi David, thanks for the feedback and glad it helped you!

  4. Saul jericho says:

    I own 4500 shares of AAPL,and sold last year 45 contracts for6/18/17 maturity $115.00 call.today the stock is at $131.00 ,what would be the best stratagey to unwind the calls and capitalize on the stock upside?
    Thanks
    Saul

    1. Gavin says:

      By selling a $115 call, you have given up the chance of any upside over $115.

  5. Joe Terrell says:

    I buy options out 2 years are more. I this wise?

  6. Joe Terrell says:

    Spell checker should say “I buy option out two years from now is this wise?”

    1. Gavin says:

      Nothing wrong with it as long as you have a plan and it meets your overall risk profile.

  7. Phil says:

    A little late, but how is there positive intrinsic value of 5$ in that “Roll out and down” scenario? Wouldn’t you lose on the sale to roll it, since underlying assets have risen, assuming it hasn’t been exercised already since in the money?

    1. Gavin says:

      Hi Paul, that’s poorly worded on my part, let me change it.

  8. Karen says:

    Thanks for the covered call info and sample illustrations to demonstrate. Very informing and helpful. Bolsters my clarity and courage to delve further as I just started to execute covered calls so learning the MATH as well as understanding the 7 plays is empowering. Appreciate your simplification and claruty.

    1. Gavin says:

      Thanks Karen, great to hear and I wish you the best on your journey. Reach out any time with questions.

  9. Paul Reiter says:

    Thanks for explaining each method clearly. If I just let a covered call expire, when am I allowed to sell another covered call on the same 100 shares? Is it one hour before close on the expiration day or do I need to wait until the following trading day? I’m just trying to maximize selling weekly covered calls. If I do decide to roll out the covered call to the following week, is there a deadline time for choosing this option? Is it one prior to close on expiration day? I’m just trying to figure out all my options

    1. Gavin says:

      Hi Paul, you would need to wait for the call to expire before selling another one, or as you said, buy it back before expiration, then you can sell another one.

      1. Paul Reiter says:

        Thanks Gavin. This is very helpful but one final question. If options expire one hour before trading closes, does this mean I can buy another weekly covered call during that final hour of trading on expiration day? I think the answer is yes but just not sure since option contracts aren’t settled yet. Just making sure.

        1. Gavin says:

          I don’t think options expire one hour before the close. Where did you get that info?

          1. Paul Reiter says:

            Yeah, you’re right. I was able to find more information. It sounds like it is still open even during after hours trading.

  10. Chris Root says:

    This is so well explained, I was able to really understanding it after reading through a few times. Very much appreciated!

    1. Gavin says:

      Thanks Chris, glad you liked it and I appreciate the feedback.

  11. chris says:

    One other possibility…
    What if you were to donate the shares when the underlying stock price has exceeded the strike on the short call? If selling the shares instead would have resulted in a long-term gain, can you deduct the entire market value of the donated shares as a charitable deduction? Could you also close the related short call and net that against other gains? If not, could you buy replacement shares, wait 31 days, and then close the call in order to net the loss against other gains?

    1. Gavin says:

      Interesting idea, but I’m not sure. Substance over form probably takes effect in your example. Also I’ve never heard of anyone donating shares before so not sure how that would even work. Sounds like maybe you’ve done it before? I’m not a tax expert, so best to check with your accountant etc.

  12. Peter says:

    I sold a covered call option. If I then simply sell the option, will I also forfeit the premium received, or is that premium always mine no matter what? Thank you!

    1. Gavin says:

      Hi Pater, the premium is your to keep, but if you want to buy the call back to close it you will have to pay the premium to close it. Depending on what the stock has done the premium paid might be more or less than you initially received when you sold the call. Let me know if that makes sense or if you need more details.

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Options Trading 101 - The Ultimate Beginners Guide To Options

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