Understanding the Math When Rolling ITM Covered Calls Out-And-Up: A Real-Life Example with Utilities Select Sector SPDR Fund (NYSE: XLU) + Save the Date May 11th – April 17, 2023
All strategies, including covered call writing and selling cash-secured puts, have their pros and cons. The same holds true for the exit strategies associated with them. Several of our members have written to me over the years regarding a “can’t lose” portfolio overwriting strategy that will return 1% – 2% per-month by selling out-of-the-money (OTM) calls and rolling the options out-and-up when the calls are expiring in-the-money (ITM). This article will highlight a real-life example with Select Sector SPDR Utilities (NYSE: XLU) showing an option-chain that will meet the stated initial time-value return goal range and factor in Delta to determine the probability of needing to roll the option out-and-up (probability of expiring in-the-money at expiration).
XLU (an exchange-traded fund or ETF) covered call writing trade
- 11/2/2022: Buy 100 x XLU at $67.26
- 11/2/2022: STO 1 x 12/2/2022 $70.00 call at $0.79
- 11/2/2022: The $70.00 call strike shows a Delta of 0.30
- Does the premium meet our stated goal?
- What is the probability of the strike expiring with intrinsic-value or ITM?
- What is the potential impact of rolling-out-and-up on our 1% – 2% monthly returns?
XLU option-chain on 11/2/2022
The Delta of the $70.00 strike reflects an approximate probability of the strike expiring ITM 30% of the time or 3 – 4 months out of a calendar year for monthly expirations. This means rolling the strike out-and-up fairly frequently to retain the out-of-the-money trade status.
The BCI Trade Management Calculator
The red arrows show a 31-day initial time-value return of 1.17%, 13.83% annualized. This meets our stated initial time-value return goal range of 1% – 2% per-month. The blue arrow shows that an additional 4.07% can be realized if share value moves up to and beyond the $70.00 strike. This means that if there is a need to roll-out-and-up, this month’s return would be 5.24% (1.17% + 4.07%). Based on the Delta stat, there is a 30% probability of this occurring.
What is the impact of rolling out-and-up?
To generate a 1-month return of 1% – 2% for XLU, the $70.00 OTM strike would do the trick. Note the Delta is 30, a 30% chance of exercise without exit strategy intervention. When this occurs, to roll-out-and-up, we do so at an option debit so that will impact overall returns.
At expiration, if the strike is ITM, the cost-to-close is the intrinsic-value of the premium + a few pennies of time-value. Let’s say XLU is trading and $72.00, the cost-to-close may be $2.05. Rolling out-and-up will generate a much lower premium. If we allow exercise and sell the shares at $70.00 and buy on Monday at $72.00 (if shares are still the same price), the debit is $2.00, $0.05 less but rolling the option protects us against further share acceleration on market open. An alternative approach if we want to generate more protection is to use a lower Delta strike (deeper out-of-the-money) and settle for lower premiums … we can’t have both.
Why this is not a “can’t lose” strategy
When share price accelerates past the out-of-the-money strike ($70.00, in this example), we will win nearly every time as we factor in upside potential as we roll out-and-up. However, if share price declines below the breakeven price point, we start to lose money or, at least, devalue the initial time-value return.
Discussion
There are no “can’t miss” strategies that seek to generate higher than risk-free returns. Rolling-out-and-up to an out-of-the-money (OTM) strike will typically result in an option debit but capture increased share value. When portfolio overwriting securities which we want to retain in our long-term buy-and-hold portfolios, we must balance the returns we receive and the strikes we select. Deeper OTM strikes with lower Deltas, will provide greater protection from the need to roll-out-and-up but also generate lower returns. Each investor must determine the sweet spot that aligns with one’s personal risk-tolerance and strategy goals.