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                                                        4339_PART4.qxd  11/17/04  12:57 PM  Page 165
Covered Call Writing In Action
165
prices are higher than they have been in recent months. If that holds truefor another month, I’ll be able to collect better prices when I write new calloptions for the August expiration. None of my options expired because Irolled all of them to July.
My results for the June expiration are summarized in Table 15.5E.I  suffered  a  setback  this  month  with  the  market  decline.  But  onceagain, covered call writing came to the rescue, reducing my losses. For ex-ample, if I had owned my ETFs unhedged, I would have lost $5,290: $2,885on 500 VTI + $1,092 on 200 MDY + $703 on 100 EFA + $610 on 200 OEF. In-stead, my losses were reduced to about half that amount ($2,865). Like anyother investor who owns stocks, I’d be much happier with a rising market,but I must admit I feel pretty good about having a profit for the year (lessthan 1 percent) when the market is down more than 8 percent.
Note: This is the first month my options still have time remaining whenan  expiration  day  arrives.  Thus,  the  value  of  those  outstanding  optionsmust be deducted from the value of my ETFs to determine the total valueof my account (see Table 15.5E).
I’m already fully invested for next month since I rolled the positions outto July. No trading is necessary Monday morning. I’ll miss my trading ac-tivity, as it’s something I look forward to every month. But I do have one im-portant decision to make, and I’ll work on it over the weekend: Am I goingto maintain the positions as they are, or should I roll the positions again bybuying back options I am currently short and replacing them with lowerstrike options? It’s very tempting to maintain my current OTM call positionsin an attempt to make extra money if the market stages a comeback. But Imust remember that my goal is to make money month after month, and Idon’t  want  to  be  in  the  business  of  predicting  which  way  the  market  isgoing to move in the future.
JULY EXPIRATION
I’ve decided to maintain my current positions in VTI, MDY, and OEF because
• The options are not too far out of the money (just over 2 points for VTI,
just over 1 point for MDY, and about 1 point for OEF).
• I can’t collect enough extra cash (after paying both a buy and sell com-mission) to make it worthwhile to roll to a different July option with alower strike price.
However,  EFA  is  sufficiently  OTM  that  I’m  going  to  repurchase  myshort Jul 142 call and substitute an appropriate option—either the 137 or138 call. I’ll know more when the market opens and I can see the currentoption prices.
4339_PART4.qxd  11/17/04  12:57 PM  Page 166
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                                                   4339_PART4.qxd  11/17/04  12:57 PM  Page 167
Covered Call Writing In Action
167
On  Monday  morning  the  markets  are  quiet  and  open  essentially  un-changed from last week’s closing prices. I decided to roll the EFA to the 137strike. The trade is listed in Table 15.6A. My positions are listed in Table15.6B.
The profit potential for this month is higher than usual, but that’s a re-sult of being short OTM call options. If the market recovers some of its re-cent losses, I’ll also recover. I don’t know what to expect, but I decided tomaintain my positions. In this respect I’m in the same boat as any unhedgedinvestor who owns stocks or mutual funds. It’s tough (for me) to hold dur-ing periods when the market is declining, but I am committed to remainingfully invested.
June turns out to be a dull month, but that’s not a bad thing. At least theslide  has  ended  for  the  time  being.  The  American  stock  market  stages  amild 1 percent comeback, but the markets around the rest of the world arefairly flat. All my options expire worthless. Next month I’ll be in position towrite ATM options again.
The results for the month of July are listed in Table 15.6C.The account made a decent recovery this month, and I’m ahead 3 per-cent  for  the  first  seven  months  of  the  year.  Since  the  market  is  downroughly 7 percent over the same time period, that’s a satisfying result.
AUGUST EXPIRATION
There was not much to ponder this past weekend, and I’ve decided to sellthe options that are a fraction of a point out of the money for my domesticETFs and the next higher strike for EFA. That’s consistent with my style ofwriting options whose strike price is nearest to the money.
The market is poised to open just a bit higher this morning, accordingto the S&P futures market. I’m going to waste no time writing options and
TABLE 15.6A July Expiration Trades
B/S/W
Qty
SYM
Price
Call
Comm
Net Cost
BW
11
EFAEFAEFA
136.021.002.70
Jul 142Jul 137
11.5011.50
Invested
Cash StartCash Now
($111.50)$258.50
$147.00
$2,981.50$3,128.50
4339_PART4.qxd  11/17/04  12:57 PM  Page 168
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                    4339_PART4.qxd  11/17/04  12:57 PM  Page 169
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        4339_PART4.qxd  11/17/04  12:57 PM  Page 170
170
CREATE YOUR OWN HEDGE FUND
should complete my trades within the first few minutes after the marketopens.
I’m  getting  more  and  more  efficient  at  this  process.  It  took  me  onlythree minutes to complete the sale of four different options expiring in Au-gust. The trades are listed in Table 15.7A.
My excess cash is building, and I want to put it to work as soon as pos-
sible. My current positions are listed in Table 15.7B.
The August expiration period begins with one of those bullish marketsthat investors love. Prices rise steadily day after day. By Wednesday of thesecond week, all my short option positions are significantly in the money,and  there  are  still  two  and  one-half  weeks  until  August  expiration.  I  cansimply wait for expiration to arrive, and I’ll probably collect the maximumpossible return my positions allow (when assigned an exercise notice oneach call). Instead, I’m making an adjustment to each position. These tradeshave a bullish bias.
Earlier, I rolled down and out to a lower strike price when the optionsI sold became significantly out of the money. The goal was to gain addi-tional protection against loss. This time I’m making the mirror-image trades(rolling up and out) because the options I sold are now significantly in themoney. I’m rolling up to a higher strike price and out to a more distant ex-piration date in an attempt to earn extra profits. The new options I write aregoing to be near the money, per my usual investment style. I’m buying backAugust  options  and  substituting  September  options  with  higher  strikeprices.
TABLE 15.7A August Expiration Trades
B/S/W
Qty
SYM
Price
Call
Prem
Comm
Invested
W
W
W
W
VTIVTI
MDYMDY
EFAEFA
OEFOEF
106.97
109.85
136.10
54.60
5
2
1
2
Aug 107
2.05
17.50
$1,007.50
Aug 110
2.10
13.00
$407.00
Aug 137
2.20
11.50
$208.50
Aug 55
0.70
13.00
$127.00
Invested
Cash StartCash Now
$1,750.00
$3,128.50$4,878.50
4339_PART4.qxd  11/17/04  12:57 PM  Page 171
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        4339_PART4.qxd  11/17/04  12:57 PM  Page 172
172
CREATE YOUR OWN HEDGE FUND
Rolling a Position Type II.  Rolling to Make Money
This time I’m entering my orders as spread transactions and having my bro-ker execute the orders. I don’t want to take the chance that I will have dif-ficulty executing the trades. I tell the broker, “I have four spread orders.
“First, in a spread transaction, buy 5 VTI Aug 107 calls to close (buy anoption sold earlier) and sell 5 VTI Sep 111 calls to open (write an option toestablish  a  new  position)  for  net  a  debit  of  $2.40.”  A  net  debit  of  $2.40means to pay no more than $2.40 more to buy the August call than you re-ceive when selling the September call.
“Second, as a spread, buy 2 MDY Aug 110 calls to close and sell to open
2 MDY Sep 113 calls for a net debit of $1.50.
“Next, as a spread, buy to close 1 EFA Aug 137 call and sell to open 1
EFA Sep 141 call for a net debit of $1.90.
“Last, take a spread order. Buy to close 2 OEF Aug 55 calls and sell to
open 2 Sep 57 calls for a net debit of $1.15.”
After entering the orders, I monitor the markets, trying to judge howeasily my orders can be executed. Some brokers are much more efficientthan others in getting spread orders filled, so I want to be certain my bro-ker is good. If not, I can change brokers or enter individual orders online.Using the broker eliminates the risk of getting a fill at bad prices but in-creases the risk of failing to complete the roll.
It turns out that I had nothing to worry about. Within the hour I’ve beennotified by e-mail that all my spread orders are filled. The trades are listedin Table 15.7C.
When  making  the  decision  to  maintain  my  current  positions  or  rollthem,  I  must  consider  risk  versus  reward.  Conservative  investors  may prefer to hold, locking in their profits. More aggressive investors are morewilling to roll the position up and out in an effort to earn more money. The
TABLE 15.7C August Expiration: Trades to Roll Positions
ETF
Qty
CurrentPrice
BoughtCalls
BuyPrice
SoldCalls
SellPrice
SpreadDebit
CashPaid
VTIMDYEFAOEF
5212
110.71113.00141.0056.65
Aug 107 $4.00 Sep 111 $1.60 $2.40Aug 110 $3.30 Sep 113 $1.80 $1.50Aug 137 $4.40 Sep 141 $2.50 $1.90$0.65 $1.15Aug 55
$1.80 Sep 57
$1,235.00$326.00$213.00$256.00
Cost to RollOld CashNew Cash
($2,030.00)$4,878.50$2,848.50
Cost to roll: Cash is negative because I paid cash to make the trades.
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Covered Call Writing In Action
173
possibility  of  extra  profits  comes  with  the  risk  of  losing  profits  alreadyearned  this  month.  There  is  no  right  decision  here.  Either  choice  is reasonable.
Note: It cost over $2,000 to roll my positions. I would have been unable
to make these trades if my idle cash reserves were not sufficient.
Rationale for Rolling a Position
Before rolling, my positions were very safe and it was very likely I wouldearn the maximum. Is there any reason to abandon these relatively safe po-sitions in an attempt to earn additional profits? Yes, there is.
Let’s  assume  the  market  stabilizes  between  now  and  August  expira-tion. I’ll be assigned on all my August calls, achieving the maximum profit.The following Monday I’ll buy the same ETFs I currently own, paying thethen current market price. If the price remains steady, I’ll be paying 111 formy VTI shares and writing VTI Sep 111 calls.
By rolling the position today, I’m also reinvesting in VTI at its currentprice  near  111.  I’m  writing  the  same  Sep  111  call  that  I’d  be  writing  if  Iwaited a few weeks. Thus, I’m not taking any more risk now than I wouldbe taking later. Thus, the question becomes: What do I have to gain or loseby rolling my positions to September now?
If  I  roll  now,  I  give  up  some  downside  protection.  If  the  market  re-verses direction and heads lower before August expiration, I’ll be worse offbecause  I  rolled  the  position.  I’m  currently  protected  against  losing  anymoney  in  my  VTI  position  if  the  market  turns  down,  as  long  as  it  staysabove 107 (the strike price of the August call I wrote earlier) when expira-tion arrives. Once I roll to the VTI Sep 111 call, that four points of protec-tion disappears.
If I roll now, I’ll have the opportunity to earn additional profits from theSeptember  expiration  cycle  because  I’ll  receive  a  higher  price  selling my September calls now (see box). It’s true I must pay some time premiumto  buy  back  my  August  calls,14 but  because  they  are  a  few  points  in  themoney, that time premium is minimal compared with the extra time pre-mium I can gain from writing September options now. 
The rolling decision comes down to this:
• Am I willing to exchange extra protection for the next two and a halfweeks in exchange for the opportunity to earn extra profits from Sep-tember expiration?
• By rolling now, I’ll lose money if the market retreats before expiration.But if the rally continues, I’ll earn additional profits because the Sep-tember  calls  carry  significant  time  premium,  and  that  time  premiumrepresents my profit.
4339_PART4.qxd  11/17/04  12:57 PM  Page 174
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Rolling Now: What I Have to Gain
It is a simple matter to calculate the theoretical value of an option usingwidely available calculators.15 For our purposes that theoretical value is agood estimate of actual option prices, but one never knows in advance ifspecial circumstances will affect those prices.
Assume VTI is 111.00 and the implied volatility is 13 percent
45 days to September expiration (rolling now)
VTI Aug 107 call theoretical value: $4.20
VTI Sep 111 call theoretical value: $2.15
Cost to roll: $2.05 (Buy Aug 107 and sell Sep 111)
26 days to September expiration (waiting until Monday, after expiration)
VTI Aug 107 call price: expired with a value of $4.00
VTI Sep 111 theoretical value: $1.65
Cost to roll: $2.35
By waiting until after expiration, I save $0.20 per option when buyingback my August calls. But I’ll receive $0.50 less when writing the Septem-ber  calls.  That  difference  represents  my  estimated gain  by  rolling  now.There is no way to know what market conditions will obtain when expira-tion day arrives, but these calculations provide a reasonable guess.
• Because I don’t have any idea if the market is going to head higher orlower, rolling now allows me to maintain my overall strategy of owingETF shares and writing options that are at the money. This is the de-ciding factor for me.
In making the decision to roll, I must make the same decision coveredcall writers face constantly: Do I want to give up the safety of my current po-sition seeking extra profits? Each investor faces this problem occasionally.Because I agree with the teachings of modern portfolio theory and acceptthe fact that I have no ability to predict the direction of the next stock mar-ket move correctly, I choose to roll the position because the risk/reward out-look is favorable. Being a conservative investor, I usually choose the moreconservative path and hold the position. But this time I’m rolling. Rolling notonly gives me the position I want (short the ATM call), but it also gives mesome experience handling the decisions required in the rolling process. Thatexperience ought to be helpful when I next face a similar problem.
Note: In June, when I rolled the position down and out, the purpose wasto  gain  protection  for  my  portfolio.  To  me  that’s  a  prudent  choice.  This
4339_PART4.qxd  11/17/04  12:57 PM  Page 175
Covered Call Writing In Action
175
month I’m rolling the position in an attempt to gain additional profits be-cause  the  risk-to-reward  factor  is  favorable.  I  don’t  expect  to  make  thistype of roll often.
The Trades (Rolling)
Let’s look at each of the four positions and compare the potential gain withthe possible loss from rolling the positions now.
VTI Position I moved the strike price 4 points higher (from 107 to 111).Because  I  paid  $240  for  each  spread  (plus  $35  in  commissions),  I’ve  in-creased my investment in VTI by $1,235 ($240 × 5 + $35). If VTI is above 111when September expiration arrives, that $1,235 turns into $2,000. (I’ll earn4 extra points on each of my 500 shares by selling at the strike price of 111instead of 107.)
MDY Position I invested an additional $150 per option to roll the strikeprices up by 3 points. I’m putting that additional investment at risk trying toturn  that  $326  (including  commissions)  into  $600  (three  points  on  200shares.
EFA Position I rolled my position 5 points higher, investing $190 plus$23 in commissions to do so. The potential profit is $310 less commission.Commissions are more significant when rolling the EFA position because Ihave only 100 shares.
OEF  Position My OEF options were less than 2 points in the money,and rolling this position is less attractive than the others. I had to choosebetween  maintaining  this  position,  thereby  providing  a  small  amount  ofprotection  for  my  investment,  and  rolling  to  make  it  consistent  with  theothers. I voted for consistency, and it cost $256 to roll the position. If theseoptions are in the money at expiration, I’ll earn an extra $144–$200 for eachoption, less the $256 cost to roll.
Summary: Rolling the Positions
If  the  market  declines  over  the  next  few  weeks,  rolling  the  positions  isgoing to cost me because I’ll lose all or part of the extra money I just addedto my investments. However, if the market continues to advance, or even ifit remains relatively unchanged from its current price level, then rolling theposition is going to prove to be profitable because I’ll keep the extra timepremium I received for writing the September options early. I’m comfort-able with rolling because I don’t want to place bets on the direction of fu-ture stock market moves.
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CREATE YOUR OWN HEDGE FUND
Is It Better To Wait Rather than Roll Now?
When trading options, you are at the mercy of how options are priced in themarketplace. The professional traders who make markets in those optionsdetermine those prices, and they in turn are influenced by order flow. Whenthere are many more buyers than sellers, option prices move higher. Con-versely, when there are many more sellers, prices move lower. In addition,