Let’s say you bought a stock for $125 and sold a 130 call for $2.00. Now both the stock and the call option are lower in value and your short-term outlook is bearish. It’s time to roll over.
If you have a covered call where the option you’ve sold has dropped in value by a substantial amount, you might decide that it’s time to buy that option to close it out, and then sell another call to re-establish your covered call position and bring in more premium. This is called “rolling.”
With the stock now at $120, buying the 130 calls to close for $1.15 and selling the 120 calls to open at $4.30 (using a short vertical spread), you’ll roll the covered call lower and take in an additional $3.15 of premium that gets added to the premium from the opening 130 call sale. This continues to lower the breakeven point of the trade.
As expiration nears, with the stock dropping to $113, the short covered call can be rolled “out and down”...out in time by one expiration, and down one strike to the 115 call. Using a short “diagonal” order, you can adjust this covered call for a credit of $5.70.
In this example you take in $10.95 in option premium, lower your breakeven level by the same amount, and offset most of your $12 loss in the stock.
By lowering the breakeven point of your stock, we see that covered calls can be used not only for income generation, but also for added protection when markets turn south. By selling lower and lower strikes, you’ll continue to lower your breakeven level. When you think your stock has bottomed, then go back to your “normal” use of the strategy by selling options further out-of-the-money than where the stock is trading.
Greg Loehr is a former CBOE market maker trained by Susquehanna Intl. Group, and founder of education firm OptionsBuzz.com. He has written and presented extensively on options globally.