Avoiding an Options Call Exercise

If you sell a call on stock originally purchased as a long-term investment, you might want to take steps to avoid exercise. This is not contradictory; as a specific strategy, you can write covered calls with the willingness to accept exercise, but with a preference to avoid it. If your primary purpose is to hold stock as a long-term investment, covered call selling enhances current income without necessarily requiring that you give up stock. The overall guideline remains the same: Never sell a covered call unless you are willing to go through exercise and give up 100 shares of stock at the striking price.

The strategy is twofold: If you would prefer to keep the stock for long-term investment growth, you need to view calls as current income generators, while also accepting the possibility that the calls might be exercised.

Call sellers—even after picking strategies well—may experience a rise in the stock and later wish to avoid exercise, in order to (a) achieve higher potential capital gains, (b) augment call premium income, and (c) put off selling a stock that is increasing in value.

You avoid exercise in two primary ways: by canceling the option or by rolling out of one option and replacing it with another. The following examples are all based on a situation in which unexpected upward price movement occurs in the underlying stock, placing you in the position where exercise is likely.


Example

Paper Profit Problems: You sold a May 35 call on stock when the stock's market value was $34 per share. The stock's current market value is $41, and you would like to avoid exercise to take advantage of the higher market value of the stock.

Method 1: Cancel the option. You can cancel the option by purchasing it. Although this creates a loss in the option, it is offset by a corresponding increase in the value of the stock. If time value has declined, this strategy makes sense—especially if the increased value of stock exceeds the loss in the option.

Example

Short-Term Loss, Long-Term Gain: You bought 100 shares of stock at $21 per share and later sold a June 25 call for 4. The stock's current market value is $30 per share and the call's premium is at 6. If you buy the call, you will lose $200; however, by getting around exercise, you avoid having to sell the $30 stock at $25 per share. You now own 100 shares at $30, and are free to sell an option with a higher striking price, if you want.

In this example, the outcome can be summarized in two ways. First, remember that by closing the call position at a loss, you still own the 100 shares of stock. That frees you to sell another call with a striking price of 30 or higher, which would create more option premium. (If you could sell a new option for 2 or more, it offsets your loss in the June 25 call.)

You can also analyze the transaction by comparing the exercise price of the option to the outcome of closing the option and selling shares at current market value. The flaw in this method is that it assumes a sale of stock, which is not necessarily going to occur; however, the comparison is valuable to determine whether avoiding exercise makes sense. A summary:
ExerciseSale
Basis in 100 shares of stock-2,100-2,100
Call premium received400400
Call premium paid-600
100 shares deliver at $252,500
100 shares sold at $302,5003,000
Net profit$800$700

This comparison appears to conclude that you have a better outcome by allowing exercise of the call. That is a fair conclusion only if you would be willing to give up the 100 shares; but it excludes two very important considerations. First, upon exercise you have a capital gain on the stock and a tax consequence. Second, if you keep stock you are free to write covered calls again after expiration or close of the current positions, meaning more income in the future. Exercise ends that possibility.

Smart Investor Tip

A careful comparison between choices is the only way to decide whether to accept exercise or to close out the whole position.

Method 2: Roll options to avoid exercise. A second technique to avoid exercise involves exchanging one option for another, while making a profit or avoiding a loss in the exchange. Since the premium value for a new option will be greater if more time value is involved until expiration, you can trade on that time value. Such a strategy is likely to defer exercise even when the call is in the money, when you remember that the majority of exercise decisions are made close to expiration date. This technique is called a roll-forward.

You still face the risk of exercise at any time; however, it is less likely with a call three months further out. In addition, if you believe that expiration is inevitable, this strategy provides you with additional income. Because the August 40 call has more time until expiration, it also has more time value premium. The roll-forward can be used whether you own a single call or several. The more lots of 100 shares you own of the underlying stock, the greater your flexibility in rolling forward and adding to your option premium profits. Canceling a single call and rolling forward produces a marginal gain; however, if you cancel one call and replace it with two or more later-expiring calls, your gain will be greater. For example, you own 300 shares and have previously sold one call; you can roll forward, replacing one call with either two or three which expire later. This strategy is called incremental return. Profits increase as you increase the number of calls sold against stock.


Example

Avoiding Exercise with More Cash: You own 300 shares of stock that you bought for $31 per share. You sold one call with a striking price of 35, and received a premium of 4. Now the stock is worth $39 per share and you would like to avoid or delay exercise. You buy the original call and pay 8, accepting a loss of $400, and replace it by selling three 35 calls with a later expiration for 4 each, receiving a total premium of 12. The net transaction yields you an extra $400 in cash: $1,200 for the three calls, minus $800 paid to close the original position.

In this example, you trade exposure on 100 shares of stock for exposure on 300 shares, but you avoid or delay exercise as well. At the same time, you net out additional cash profits, which reduces your overall basis in the stock. This makes exercise more acceptable later on. Of course, you can continue to use rolling techniques to avoid exercise. Another important point worth evaluating is the potential tax advantage or consequence. Options are taxed in the year that positions are closed; so when you roll forward, you recognize a loss in the original call transaction, which can be deducted on your current year's federal income tax return. At the same time, by rolling forward you receive a net payment while deferring profits, perhaps to the following year. However, because the roll-forward may involve in-the-money positions, the stock profit may revert to a short-term gain instead of the more favorable long-term gain. Strategies involving tax problems are examined in Risk and Taxes: Rules of the Game.

The roll-forward maintains the same striking price and buys you time, which makes sense when the stock's value has gone up. However, the plan does not always suit the circumstances. Another rolling method is called the roll-down.

Example

Repetitive Profits: You originally bought 100 shares of stock at $31 per share, and later sold a call with a striking price of 35, for a premium of 3. The stock has fallen in value and your call now is worth 1. You cancel (buy) the call and realize a profit of $200, and immediately sell a call with a striking price of 30, receiving a premium of 4.

If the option is exercised at its striking price of 30, the net loss in the stock will be $100; but your net profit in option premium would be $600, so your overall profit would be $500:
Striking price of shares$3,000
Less original price of shares-3,100
Loss on stock-100
Profit on first call sold200
Profit on second call sold400
Net profit$500

The roll-down is an effective way to offset losses in stock positions in a declining market, as long as the price decline is not severe. Profits in the call premium offset losses to a degree, reducing your basis in the stock. This works as long as the point drop in stock does not exceed the offset level in call premium. You face a different problem in a rising market, where the likelihood of exercise motivates you to take steps to move from in-the-money to out-of-the-money status, or to reduce the degree of in-the-money. In that situation, you may use the roll-up.

Example

Trading Losses for Profits: You originally paid $31 per share for 100 shares of stock, and later sold a call with a striking price of 35. The stock's current market value has risen to $39 per share. You cancel (buy) the call and accept a loss, offsetting that loss by selling another call with a striking price of 40 and more time to go until expiration.

With this technique, the loss in the original call can be replaced by the premium in the new call. With more time to go until expiration, the net cash difference is in your favor. This technique depends on time value to make it profitable. In some cases, the net difference will be minimal or may even cost money. However, considering you will be picking up an extra five points in the striking price by avoiding exercise, you can afford a loss in the roll-up as long as it does not exceed that five-point difference.

Smart Investor Tip

Rolling techniques can help you to maximize option returns without going through exercise, most of the time. But the wise seller is always prepared to give up shares. That is the nature of selling options.

It is conceivable that the various rolling techniques can be used indefinitely to avoid exercise, while continuing to produce profits. Figure below provides one example of how this could occur.

[caption id="attachment_12494" align="aligncenter" width="421"]Using the rolling technique to avoid exercise. Using the rolling technique to avoid exercise.[/caption]


Example

Staying Ahead of the Curve: You own 800 shares of stock that you bought at $30 per share; your basis is $24,000. You expect the value of the stock to rise, but you also want to write covered calls and increase profits while providing yourself with downside protection. So on March 15, you sell two June 30 contracts for 5 apiece, and receive payment of $1,000.

On June 11, the stock's market value is at $38 per share. To avoid exercise, you close the two calls by buying them, paying a premium of 8 each (total paid, $1,600). You replace these calls with five September 35 calls and receive 6 for each, getting a total of $3,000.

On September 8, the stock's market value has risen again, and now is valued at $44 per share. You want to avoid exercise again, so you cancel your open positions and pay a premium of 9 each, or $4,500 total. You sell eight December 40 calls in replacement at 6 each, and you receive a total of $4,800.

By December 22, the day of expiration, the stock has fallen to $39 per share. Your eight outstanding calls expire worthless. Your total profit on this series of transactions is $2,700 in net call premium. In addition, you still own 800 shares of stock, now worth $39 per share, which is nine points or a total of $7,200 above your original basis. If you wish, you can begin selling calls again, now that all short positions have expired.

For the volume of transactions, you might wonder if the exposure to exercise was worth the $2,700 in profit. It certainly was, considering that the strategy here was dictated by rising stock prices. While you received a profit on call options premium, you also avoided exercise as prices rose. Upon expiration of the calls, you are free to repeat the process. The incremental return combining roll-up and roll-forward demonstrates how you can avoid exercise while still generating a profit. You cannot depend on this pattern to continue or to repeat, but strategies can be devised based on the situation. It helps, too, that the example involves multiple lots of stock, providing flexibility in writing calls.

This example is based on the premise that you would have been happy to accept exercise at any point along the way. Certainly, exercise would always have been profitable, considering original cost of shares, option premium, and striking prices. If you were to sell the 800 shares at the ending market value of $39 per share, total profit would have been substantial using covered calls, with 41.25 percent profit based on original cost of the stock:
Stock
Sell 800 shares at $39$31,200
Less original cost-24,000
Profit on stock$7,200
Options
Sell 2 June contracts$1,000
Buy 2 June contracts-1,600
Sell 5 September contracts3,000
Buy 5 September contracts-4,500
Sell 8 December contracts4,800
Profit on options$2,700
Total profit$9,900
Yield41.25%

Whenever you roll forward, higher time value is a benefit. Greater premium value is found in calls with the same striking price but more time before expiration. The longer the time involved, the higher your potential future income from selling the call. In exchange for the higher income, you agree to remain exposed to the risk of exercise for a longer period of time. You are locked into the striking price until you close the position, go through exercise, or wait out expiration.

Smart Investor Tip

The key to profiting from rolling forward is in remembering that the longer the time until expiration, the more time value there will be in the call.


Example

Rolling Along: You own 200 shares of stock originally purchased at $40 per share. You are open on a short June 40 call, which you sold for 3. The stock currently is worth $45 per share, and you want to avoid being exercised at $40. Table shows current values of calls that are available on this stock. A review of this table provides you several alternatives for using rolling techniques.

Your strategies to defer or avoid exercise combine two dissimilar goals: increasing your option income while also holding on to the stock, even when market value is above striking price. This can be achieved through profiting from higher time value, in recognition of the probability that options will not be exercised until closer to expiration date. Most exercise occurs at or near expiration.

Current Call Option Values

Current Call Option Values

Expiration Month
Striking PriceJuneSept.Dec.
35111315
406810
45125
Strategy 1: Rolling up and forward. Sell one December 45 call at 5 while closing out the original June 40 call at 6. This produces a net cash payout of $100, but puts you at the money, removing the immediate risk of exercise. Because the striking price of the new short position is five points higher, you will earn $500 more in profit if the new call is eventually exercised.

Strategy 2: Rolling with incremental return. Sell two September 45 calls while closing the June 40 call at 6, producing $200 cash difference. You receive $400 for the two new short calls, versus the $600 you pay to close the original call. Now you are at the money on two calls, instead of being in the money on one.

Strategy 3: Rolling forward only. Sell one September 40 call at 8 while closing the June 40 call at 6, resulting in net cash received of $200. You're still in the money, but you increase premium income by two points.

Note in these strategies that we refer to the loss on the June call. Because that call currently is valued at 6, it requires a cash outlay of $600 to close the position. You received $300 when you sold, so your net loss is $300.

The loss of $300 is acceptable in all of these strategies because either the call with striking price of 40 is replaced with a call with a striking price of 45, which is 5 points higher, or additional income is produced to offset that loss by replacing the call with others that will expire later.

If the underlying stock is reasonably stable—for example, if its market value tends to stay within a five-point range during a typical three-month period—it is possible to employ rolling techniques and avoid exercise indefinitely, as long as no early exercise occurs. As stated before, however, you have to remember that when your short positions are in the money, exercise can occur at any time. Rolling techniques are especially useful when stocks break out of their short-term trading ranges and you want to take advantage of increased market value while also profiting from selling calls—while also avoiding exercise.

To demonstrate how such a strategy can work, refer to Table . This shows a series of trades over a period of 2½ years, and is a summary of a series of trades taken from actual confirmation receipts. The investor owned 400 shares of stock. Sale and purchase price show actual amounts of cash transacted including brokerage fees, rounded to the nearest dollar. The total net profit of $2,628 involved $722 in brokerage charges, so that profits before those charges were $3,350.

The information in Table below shows each type of rolling trade and summarizes how an effective use of incremental return helps avoid exercise as the underlying stock's market value increases. This investor was willing to increase the number of short calls to avoid exercise, as long as all were covered by shares of stock. When the stock's market value fell, the investor rolled down but did not write calls below the original striking price of 35.

Current Call Option Values

Selling Calls with Rolling Techniques

SoldBought
Calls TradedTypeDateAmountDateAmountProfitNotes
1Jul 353/20$3284/30$221$107
1Oct 356/2723510/878157
1Apr 351/152474/14434-187
1Oct 354/146046/242283761
1Oct 357/313539/12971-618
2Jan 459/1291512/161727432
2Apr 4512/163792/24184195
4Jul 403/91,3575/263859723
4Oct 406/51,5537/221,036517
4Jan 408/51,5049/15138366
Totals$7,475$4,847$2,628

1A roll-forward: The loss on the April 35 call was acceptable to avoid exercise, since the October 35 was profitable.
2A combination roll-forward and roll-up: The loss on the October 35 call was acceptable to avoid exercise at a low striking price. The number of calls was incrementally increased from one to two.
3A roll-down combined with an incremental return: The number of calls changed from two to four, and the striking price of 45 was replaced with one for 40.

If you purchase shares primarily to write options—a common practice—chances are that you will pick issues more volatile than average, since these tend to be associated with higher-premium options. The strategy makes sense in one regard: You will have ample opportunity to take advantage of momentary price swings and their corrections by timing option trades. Volatile issues are attractive to option sellers because of their tendency to have higher time value; however, that is also a symptom of the stock's greater market volatility and thus lower safety as an investment.

Smart Investor Tip

Stocks whose options offer greater time value do so for a reason. As a general rule, those stocks are higher-risk investments.

[caption id="attachment_12495" align="aligncenter" width="300"]Example of uncovered call write with profit and loss zones. Example of uncovered call
write with profit and loss zones.[/caption]

You will be less likely to succeed if you buy overpriced stocks that later fall below your basis. No call seller wants to be exercised at a level below the basis in the stock. A comparison of risks between uncovered and covered calls is instructive. Check Figure above. This shows the profit and loss zones for an uncovered call write. In this case, a single May 40 call was sold for 2. This strategy exposes the investor to unlimited risk. If the stock rises above the striking price and then exceeds the two points equal to the amount received in premium, losses rise point for point with the stock. Upon exercise, this investor will have to deliver 100 shares of stock at $40 per share, regardless of the current market value at that time.

The example of a covered call write shown in Figure below demonstrates that the loss zone exists only on the downside, so the covered strategy has a much different profile than the uncovered call strategy. In this example, the investor owned 100 shares of stock that originally were purchased at $38 per share. The investor then sold a May 40 call for 2. This discounts the basis in stock by $2 per share, down to $36. As long as the stock's market value is at or below the striking price of 40, exercise will not occur. If the stock's market value rises above $40 per share, the call will be exercised and the 100 shares called away at $40 per share. In the event of exercise, profit would be $400—$200 in profit on the stock plus $200 for call premium.

[caption id="attachment_12496" align="aligncenter" width="300"]Example of covered call write with profit and loss zones. Example of covered call
write with profit and loss zones.[/caption]

Rolling up, forward, or down makes sense as long as you (1) create a net credit in the exchange of cash and (2) defer or avoid exercise. Two important points to remember, however, about rolling:
  1. You can create a tax problem if you don't keep the rules in mind. The idea of rolling forward makes sense as long as the striking price of the new option is close to the current market value of the stock. But the federal tax rules include an oddity, and rolling can create unintended consequences if you are not aware of it. Rolling involves two separate transactions, closing out a previous short option and opening up a new one. Under the federal rules, if the covered call you open today (even if it is part of a rolling strategy) is in the money by more than one increment (usually five points, sometimes less), you could lose the long-term capital gains treatment on your stock. (this is explained in more detail in Selling Puts: The Overlooked Strategy.) So in rolling forward, make sure you don't jeopardize the status of your long-term capital gains if and when stock is called away.
  2. It sometimes makes sense to lose a little now to avoid exercise. The concept of cutting your losses applies to covered calls as well as to any other kind of investment strategy. For example, if you sold a covered call with a striking price of 30 when the stock was at $28 per share, that was a sensible move. But if the stock has since moved up to $34 per share, your covered call is likely to be exercised. At the time you entered the strategy, you were aware of this possibility, and you accepted the risk. But now, you would like to avoid exercise by rolling up. For example, you may be willing to close your 30 call and replace it with a 35 call expiring later. In some cases, you will not be able to achieve this exchange without spending a little more (to close the previous call) than you receive (to open the new call). So you have to make a decision. Considering that the roll-up increases potential exercise price by five points ($500), is it worth the loss in the two-part rolling transaction? If the net difference is only $100, it could be worth the loss to "buy" five points in future exercise level. This also gets you away from the in-the-money exposure, if only by a single point.

If you do decide to exchange one option for another and take a small net loss, remember to track the net difference for the net call. Its net basis will not be what you sold it for, but the net between its sale price and the loss you took on the previous call. For example, if you sold the first call and received 2 ($200) and later closed it at 3 ($300), you have a net loss on $100. But you then open a new covered call at 1.50 ($150) with a strike price five points higher and exercise three months later. Your net basis in the new covered call is 0.50 ($50). The premium you received of $150 has to be reduced by the net loss on the previous call of $100. In this situation, you have reduced the overall option premium to $50 in exchange for a five-point increase in the strike price.

This example makes the point that timing and selection of the best striking price are crucial to the long-term success of your covered call program. If you pick stocks based on richness of time value premium, you should know ahead of time that you are exposing yourself to greater volatility; if you pick stocks with very narrow trading ranges, option premiums will be low as well. Either strategy has its good points, but it's crucial to know ahead of time what level of risk you will face. You can cover a short call and transform a high-risk strategy to a very conservative strategy. The task is not quite as easy for short put writing. The next chapter explains how this works and demonstrates how put writing can be very profitable or advantageous in a number of different ways.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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