Systematic Covered Writing
... more than just covered calls!
Should we allow Assignment ... or Roll the Existing Option?
This question may arise from time to time. For sure, it is specific to positions where the existing call option is
either the Initial Call Option, a Continued Trade option, or an Appreciated Trade option. By definition, in each case, it would be
'okay' for the option to be exercised which would result in the position going back to cash. There is an underlying assumption implied
with this question. One would WANT to continue to have exposure to the underlying stock. If this were not the case, there would be no
reason to consider rolling the existing option.
Another 'requirement' for using this thought process would be that
the current price of the stock is trading higher than the original purchase price, which in turn leads to the main reasons for rolling
the existing call. Please note ... these points are not necessarily in order of importance:
Available Funds - At times the may be minimal funds in the money market. If a position goes
back to cash, it will do so at a given strike price. Because we know the fees involved in an assignment, we know exactly how much
cash we would have available from the combination of the proceeds from the liquidation, and the cash that was already in the money
market. In other words ... there may be times where allowing a position to go back to cash would preclude the same equity from being
used in establishing a new Initial Position.
Cost Basis - There may also arise situations where we 'like' a stock at the old purchase
price, and not necessarily at a higher one. If we can effectively roll an option to prevent assignment, we would maintain the
original cost basis. Because stocks move up and down over time, the lower the cost basis, the 'safer' the position. If a company
pays a dividend, a lower cost basis would also provide a higher yield.
Let's consider these situations with an example. Before we do ... a misconception about the relationship between the
purchase price of stock, and the premiums received from call options.
There are basically
two schools of thought. One is correct ... the other is not!
There are those that advocate the premiums from call options lower the cost basis of the
stock purchased prior to the sale of the call. IMO this stems from the fact that if a stock is assigned by an Initial Call Option in
a taxable account, one can deduct the proceeds received from the call from the purchase price of the stock and only report two
transactions to the IRS. One would be the proceeds from the sale of the stock, and the other would be the purchase price of the
stock less the proceeds from the call. Keep in mind ... one CAN report it this way, but it is NOT a requirement to do so.
Exactly the same gain or loss would be created by reporting two separate equity transactions.
One would be the cost of the stock when it was purchased and the proceeds from its liquidation. The other would be the proceeds from
the sale of the call and its 'cost', which happens to be zero when it is exercised. the bottom line is exactly the same.
Interesting to note that if the same option in the discussion above expired worthless, meaning the stock was NOT
assigned, then the investor would need to report the proceeds from the sale of that option to the IRS as a separate transaction. The
assumption here is that the underlying stock remained in a given account into the following tax year. In this scenario ... which happens
relatively often, would the option reduce the cost basis of the stock at any point? Needless to say, the answer is no. For this reason,
we advocate keeping the call option activity separate from the stock transactions.
In
discussing plausible reasons for rolling an option, let's consider the following position from January 2011
The position above would be assigned in January if the price of KBH remained above $14 a share. It is important to note that
there is a desire to continue to hold KB Home stock in this portfolio. With this in mind, we either allow assignment to take place,
or we prevent assignment by rolling the Jan $14 option. As stated above ... is there a good way to decide which path to take?
If we had limited funds in the portfolio, and we allowed assignment, we would not be able to reenter a KBH position based on the
current price. This is because we would only receive $1,400.00 - $17.00 = $1,383.00 when the $14 option was exercised. Needless to
say, we cannot buy 100 shares of stock trading at $14.84 a share with only $1,383.00!
NOTE: This
has been stated a number of times, but always remember that when you
annualize the return, you are assuming the transactions could be executed
through out the course of a year. There is no guarantee this can
be accomplished ... one could do better or worse on subsequent positions.
This information is provided for
educational purposes only and should not be considered
as otherwise. No example or statement presented should be construed
as a recommendation to buy or sell a security, be it a stock or call option. In addition, please consult your tax, or legal, advisor for
questions concerning your personal tax or financial situation.
SYSTEMATIC COVERED WRITING
Copyright © 2006. All rights reserved.
Revised:
01/12/11