How to Roll Covered Call for Additional Monthly Income: Option Trading For Beginners

Rolling Covered Calls for Additional Income: A Detailed Guide

Introduction to Covered Calls

A covered call is an options strategy where an investor holds a long position in a stock and sells (writes) call options on the same stock to generate additional income. The call option gives the buyer the right, but not the obligation, to purchase the stock at a specified price (strike price) within a certain period (before the expiration date). By selling the call option, the investor receives a premium, which can provide a return on the stock position even if the stock does not move significantly.

However, there are times when the call option is likely to be exercised, meaning the stock will be called away from the investor at the strike price. In such cases, or when the investor wants to continue holding the stock and generating additional income, they may consider "rolling" the covered call to the next month.

What Does It Mean to Roll a Covered Call?

Rolling a covered call involves closing an existing covered call position and simultaneously opening a new covered call position with a later expiration date, often with a different strike price. This strategy allows the investor to extend the time horizon of their covered call, potentially generating more income and adjusting their exposure to market movements.

Reasons to Roll a Covered Call

1. Avoid Assignment: If the stock price is approaching or has surpassed the strike price of the call option, there's a high likelihood that the option will be exercised. Rolling the call to a future expiration can help avoid assignment while maintaining the covered call position.
2. Maximize Income: By rolling the call option, the investor can continue to collect premiums. This can be particularly beneficial if they believe the stock will remain range-bound or rise gradually over time.
3. Adjust Strike Price: Rolling the call gives the investor the flexibility to adjust the strike price to better align with their outlook on the stock. For instance, if the stock has risen significantly, they might roll the call to a higher strike price to capture more upside potential.
4. Extend Duration: By rolling the covered call, the investor can extend the duration of the trade, giving the stock more time to move in the desired direction.

How to Roll a Covered Call

Rolling a covered call typically involves two transactions:

1. Buy Back the Existing Call Option: The first step in rolling is to buy back the short call option that was previously sold. This closes the current covered call position. The cost to buy back the call will depend on the stock's current price relative to the strike price and the time remaining until expiration.
2. Sell a New Call Option with a Later Expiration Date: After closing the current position, the next step is to sell a new call option with a later expiration date. The investor may choose the same strike price, a higher strike price (for more upside potential), or a lower strike price (for more premium income).

Example of Rolling a Covered Call

Let's assume you own 100 shares of XYZ stock, currently trading at $50 per share. You initially sold a covered call with a strike price of $55, expiring in one month, for a premium of $1 per share. As the expiration date approaches, XYZ is trading at $54, and the option premium has increased to $2. You believe the stock has more room to grow and want to avoid assignment, so you decide to roll the covered call.

1. Buy Back the Current Call Option: You buy back the $55 strike price call option for $2, incurring a $1 per share loss compared to the original premium received.
2. Sell a New Call Option: You sell a new covered call with a $55 strike price expiring in the following month for $2.50 per share, generating a net premium of $0.50 per share after accounting for the loss on the original call.

In this example, rolling the covered call allows you to extend the position by another month, potentially capturing more premium income while keeping your stock position intact.

Considerations When Rolling Covered Calls

1. Transaction Costs: Rolling involves additional commissions and fees. It's important to factor in these costs when deciding whether rolling is worthwhile.
2. Market Outlook: Consider your outlook for the stock when choosing a new strike price and expiration date. If you expect significant price movement, rolling to a higher strike price might be preferable.
3. Tax Implications: Rolling covered calls can have tax consequences, particularly if the underlying stock is sold as a result of assignment. Consult with a tax professional to understand how rolling may impact your tax situation.
4. Risk Management: Rolling covered calls does not eliminate the risks associated with holding the underlying stock. It's important to continue managing the overall position based on your risk tolerance and investment objectives.

Conclusion

Rolling covered calls to the next month is a strategic approach that allows investors to continue generating income from their stock positions while adapting to changing market conditions. By carefully selecting strike prices and expiration dates, investors can optimize their covered call strategy to align with their financial goals. However, it's crucial to weigh the benefits against the potential costs and risks before deciding to roll a covered call.

When executed properly, rolling covered calls can be an effective tool for enhancing returns and managing risk in an investment portfolio.

Example of a Covered Call on NVDA (NVIDIA Corporation) Shares

Scenario Overview:

Let's say you own 100 shares of NVIDIA Corporation (NVDA), and the current stock price is $450 per share. You believe that NVDA will trade sideways or rise slightly over the next month but don't expect a significant price increase. To generate additional income, you decide to sell a covered call option on your NVDA shares.

Step 1: Choosing the Call Option

• Current Stock Price: $450
• Strike Price of Call Option: $460
• Expiration Date: 1 month from today
• Option Premium Received: $10 per share

In this scenario, you choose to sell a call option with a strike price of $460, which is slightly above the current stock price. The option expires in one month, and you receive a premium of $10 per share for selling the call.

Step 2: Potential Outcomes

Outcome 1: NVDA Stays Below $460 at Expiration

• Scenario: If NVDA’s stock price remains below $460 by the option’s expiration date, the option will expire worthless, and the buyer will not exercise it.
• Result: You keep the $10 premium per share ($1,000 total), and you continue to own your 100 NVDA shares. Your effective cost basis on the shares is reduced by the premium received.

Outcome 2: NVDA Rises Above $460 at Expiration

• Scenario: If NVDA’s stock price rises above $460, the option buyer will likely exercise the call option. You will be required to sell your 100 shares at the $460 strike price.
• Result: You still keep the $10 premium per share ($1,000 total), but you must sell your 100 NVDA shares at $460 each. Your total profit will be the difference between your purchase price and the strike price, plus the premium received.

Example Profit Calculations

Case 1: NVDA Stays Below $460

• Stock Price at Expiration: $450
• Premium Received: $1,000 (100 shares * $10 premium)
• Stock Value Change: No change
• Total Profit: $1,000

Case 2: NVDA Rises Above $460

• Stock Price at Expiration: $470
• Premium Received: $1,000
• Stock Sale Price: $460 per share (because of the call option being exercised)
• Capital Gain on Stock Sale: ($460 - $450) * 100 shares = $1,000
• Total Profit: $1,000 (premium) + $1,000 (capital gain) = $2,000

Key Considerations

• Max Gain: Your maximum gain occurs if NVDA rises slightly above the strike price of $460. This scenario allows you to collect the premium and a capital gain on the stock.
• Risk: The primary risk is that NVDA could rise significantly above $460, and you would miss out on those potential gains since your shares would be sold at the $460 strike price.

Conclusion

Selling a covered call on NVDA shares allows you to generate additional income from the stock you already own. However, it also caps your upside potential if NVDA's stock price rises significantly. This strategy is best used when you have a neutral to slightly bullish outlook on the stock and are willing to sell the stock if the price reaches or exceeds the strike price.