Can I get more out of a deep ITM covered call?

July 29th, 2009 · 7 Comments

About two weeks ago, I made a covered call play with AFL and the $31 strike for August expiration.  AFL closed yesterday at $36.60, so my call is deep in-the-money.  Looks like I way misjudged where AFL might end up, though we’re still 24 days away from expiration.  I’m wondering what I should do to try and capture more of that run up for myself?



A first thought, somewhat unrelated to simply capturing more income for myself, is that I’m wondering whether the deep ITM status will have any effect on the likelihood of assignment prior to the ex-dividend date for AFL?  It seems to me that it might be more likely for someone to want to exercise early since the trade is already profitable for them, and this way they can get the extra profit from the dividend.  But perhaps I’m simply misjudging the value in holding the option itself out to expiration due to my own knowledge of trading strategies?  Unfortunately, I have not found any guidelines or statistics on this subject anywhere.  Knowing the liklihood of early exercise would certainly have an effect on my own strategy.

As mentioned in comments on the original blog posting, I have been researching roll trades that might help capture more income from the price run up in AFL.  The more profitable trades involve rolling to something just barely in the money or out of the money (due to the higher time premium associated with those options) but there’s also more risk of non-assignment.  Let’s look a little deeper though.

I’ll explain what I mean by “more profitable” using the mid-point between bid & ask for yesterday’s last option trading prices.  For a roll to AJO HG ($34 Aug09), I’d BTC (buy-to-close) AJO HE for $5.90 and then STO (sell-to-open) AJO HG for $3.45, for a total net debit to me of $2.45.  If the call gets assigned, I’d get paid  an additional $3 per share due to the difference in strike price, thus giving me a profit of $0.55/share, before comissions.  I expect TradeKing commissions to come out to about $0.12/share on this, so I’d really net about $0.43/share.   Compare this to a roll to AJO HK ($36 AUG09) which is just ITM at yesterday’s closing price.  Here the net debit is $4.35 but the difference in strike is $6, for a profit of approximately $1.53/share — this is certainly an improvement in my overall return.  In fact, it almost doubles the annualized yield (it would be about 204%) even considering the larger capital investment used in the trade.

However, all that analysis is predicated on assignment happening.  How do these trades work out if assignment does NOT happen?  With the roll to AJO HG, I’ve paid an additional $2.57 for the trade (note the inclusion of commissions), which means I’ve increased the basis cost of my shares by that amount.  Since my original basis cost was $28.86, that means it is now $31.43 which is just a bit higher than the original out-of-pocket cost for my underlying AFL shares.  If AFL doesn’t close above that at expiration, I’ve got paper losses on this whole adventure which is a significantly different mental state than the idea of having achieved an income by selling the original covered call.   With the roll to AJO HK, things look even riskier.  My basis price would be about $33.32.

In tracking these numbers over a couple days, it has become very clear that the amount I can get out of any roll trade like this is very much dependent on the time premium the option I’m rolling to contains.  Thus, since the time premium decays as expiration gets closer, it would be better to make a trade sooner rather than later.  However, there are always later expiration options to consider as well, say September expiration.  From my analysis, there isn’t currently a huge jump in profit to me by rolling out to a September expiration when compared to August expiration at the same strike.  Which means that the annualized yield takes a nosedive due to the significantly longer holding period.  So I’m thinking it’s better to capture a slightly smaller profit now, and look for another opportunity after August expiration.  On the other hand, if I don’t do a roll trade now, I’ll need to re-evaluate a roll out to September right before August expiration because the difference in time premiums will be much greater.

I have yet to pull the trigger on a roll trade like any discussed here.  I’ve just not come to terms with the risk vs. reward balance yet.   It is worth noting that I did the original covered call strategy using AFL explicitly because I was willing to hold the shares for more than a month, so perhaps the risk of non-assignment should be discounted more than I’m currently thinking?

Tags: Options

7 responses so far ↓

  1. 1 Brandon // 2009.07.29 at 7:48 am

    What are you going to do with the money between the August expiration and the September expiration? Rolling forward to a September option reduces the annualized return of the trade, but so does the alternative of getting assigned and holding the funds in cash/money market. Option expirations only come around 12 times per year, so shortening your days held to make the trade look more profitable on an annualized basis is a small delusion, because you won’t be able to replicate that trade in the intervening periods. Is rolling to the September option better than holding in money market for 2 weeks and then making another option trade?

  2. 2 davmp // 2009.07.29 at 10:11 am

    @Brandon: Some clarification might be in order here. When I said there isn’t a huge profit to me for looking at Sept expiration, I meant that the absolute dollars returned are almost the same for selling the same strike in Aug and Sept — at least for the few strikes I looked at. The non-time-based yield is less than 2% different. On my position, that amounts to earning an extra $60-ish for holding the position for an additional 28 days.

    But perhaps I misunderstood your question. Were you referring to the money that needs to be added to the current position to do the roll, or the money that would be returned on assignment come August expiration? The former is not large enough to establish its own covered call position, either now or after August expiration, and I am considering other uses for it if I don’t use it to do this roll trade. The latter would almost definitely be immediately turned around into a new covered call where I’d have the flexibility to look for a better return for the Aug 22-Sep 20 time period. I don’t expect it to be too difficult to beat the $60 in profit I’d be locked into now by doing an AFL roll to Sept expiration.

  3. 3 davmp // 2009.07.29 at 12:05 pm

    Glad I decided to hold off on rolling to a $36 strike given that AFL is down $1.75, to $34.86, as I write this. Keep in mind that I’m generally looking to be assigned at August expiration so I can find the “best” trade each month.

  4. 4 Rich // 2009.07.30 at 2:30 pm

    It has been my experience that you can’t have sellers or buyers remorse when doing covered calls. You need to get the “emotion” out of your trading and have a goal and strategy in mind. The hardest thing for me to teach people is the art of knowing when to quit and being happy with the trade you originally made. Any trade that results in a positive net flow of money is a good thing but when you begin regretting a transaction because of the “I coulda had….” then you immediately begin to doubt yourself and that leads to lack of self discipline.

    You’re trading for a reason right? To buy a house or car or for retirement? Set the goal and build your profits toward that goal and the trading strategy will make a whole lot more sense in my opinion.

  5. 5 davmp // 2009.07.31 at 12:02 am

    Hi Rich. You make a good point, but I’m honestly surprised that you get that vibe from what I’ve written. I re-read what I wrote above, and I wouldn’t classify my writings (or my thoughts) as remorse or “I coulda had…”. I will readily admit that I *am* trying to figure out how to make the most of the opportunities I have, and writing about what I’ve “learned” — which I quote because I’m not sure I’ve done any such thing yet, though I’ve definitely come up with some theories and ways to track a couple results using theoretical trades.

    To be exceedingly explicit, I’m not unhappy at all with my second-ever covered call being a trade that yields a 100%+ annualized gain, which is what I’m looking at if I do nothing and AFL closes above $31 at August expiration. Another reason I’m not feeling the “I coulda had…” regrets is that I am also long AFL in an “investment” account.

  6. 6 davmp // 2009.08.07 at 8:57 am

    Just a quick link to one possible explanation for early option assignment:

  7. 7 davmp // 2009.08.11 at 1:13 am

    Another data point regarding early assignment: “Fact is, according to the Options Clearing Corporation (OCC) about 17% of options contracts get exercised BEFORE expiration hits.” — from a TradeKing blog by OptionsGuy

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