Rolling-Down to an ITM Strike in the Last Week of a Monthly Contract – November 8, 2021
When we roll-down our covered call trades, we generally do so to an out-of-the-money (OTM) strike to allow for share price recovery. However, in the final week of a monthly contract, if we hold a security, we will not use in the following contract month, it frequently makes sense to roll-down to an ITM strike. This will have 2 positive impacts on our trade: First, we will benefit from the time-value premium component of the ITM strike. Second, we will generate additional downside protection via the intrinsic-value component of the option without the disadvantage of assignment risk since we have decided to eliminate this security from our portfolio for the upcoming contracts.
A real-life example with Materials Select Sector SPDR Fund (NYSE: XLB)
- 5/24/2021: Buy 300 x XLB at $87.18
- 5/24/2021: STO 3 $88.00 calls at $1.44
- 6/11/2021: BTC the $88.00 calls at $0.15 (10% guideline)
- 6/11/2021: STO the $87.50 calls at $0.20 (roll-down #1 to an OTM strike for a small credit)
- 6/15/2021: BTC the $87.50 calls at $0.02 (10% guideline)
- 6/15/2021: XLB trading at $84.30
- 6/15/2021: STO the $84.00 calls at $0.75 (roll-down #2 to an ITM strike)
Pros & cons of rolling-down to the ITM strike
Pros: We are generating an additional time-value profit of $0.45 per-share ($0.75 – $0.30) as well as an additional downside protection of $0.30 per-share (84.30 – $84.00).
Con: We are locking in a share loss of $3.18 ($87.18 – $84.00)
Broker statement showing rolling-down to the $84.00 ITM strike
How did covered call writing plus position management maneuvers mitigate the loss of $3.18 per-share?
The 3 option sales totaled a net premium of $2.39 per-share. The option debits (BTC) totaled $0.17 resulting in a net option credit of $2.22 per-share. The net loss of the XLB trades were mitigated from $3.18 per-share to $0.96 per-share.
Discussion
Not all our trades will be profitable. Exit strategy execution will mitigate losing trades and enhance returns on our winners. Position management is the 3rd critical required skill for successful option trading. When we roll-down in the final week of a monthly contract on shares we will not be considering for the next contract period, we can roll-down to ITM strikes which generate both time-value and intrinsic-value without the concern of assignment risk.
Author: Alan Ellman