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Subject:  Cure for Covered Call Root Canal Date:  3/12/2015  3:56 PM
Author:  davidbjonas Number:  11026 of 11360

A covered call investor's most painful experience is watching a company's share price soar far beyond the strike price of a call that the investor has sold short.

The investor stands by helplessly, as every penny of share price appreciation falls off the table and into the grubby paws of the option buyer (I realize that's a harsh assessment; rest assured that we option sellers are much more charitable towards longs when they are on the wrong side of a trade.) A kind of death watch sets in, as the investor morbidly counts the days until option expiration, praying for early assignment to put you out of your misery.

It is the investing equivalent of root canal, but without the anesthesia: You just can't wait till it's over.

But cheer up - here's a technique you can deploy to transform your root canal-like agony to Shiatsu-like bliss:

1. Determine the cost to close the call.

2. Determine the 'lost upside' you will recoup if you sell the shares, by subtracting the strike price from the current market price.

3. Subtract 1. from 2. to determine your net cost for two trades.

4. Determine the trading costs you will incur by executing the two trades.

5. Subtract 3. and 4. from the cumulative income you will earn (from share appreciation and option premium) if you hold the shares until option expiration.

6. Calculate the new annualized yield on the covered call, taking into consideration your additional costs (items 3. and 4.) and the accelerated expiration date (i.e. the day on which you close the position).

Depending on the degree of time decay, and the delta between strike price and market price, you might actually increase your annualized yield, even though the two trades will result in a net debit. You will liberate your money for reinvestment into another opportunity.

Two Examples

Here are two real-life examples that illustrate this technique. One is from my portfolio, and the other from my brother-in-law Ian's. (From the examples you'll be able to infer which of us is the retired physician, and which majored in humanities.)

On January 20,2013, Ian purchased 500 shares of the electric car maker Apple (AAPL) for a split-adjusted price of $69 per share. Over the next year and a half, he sold or rolled calls on those shares seven times. The seventh call was a $95 option expiring April 17, 2015, which he sold in July 2014.

As AAPL's share price headed north of $95, Ian's demeanor drifted south. By nature sunny and free-spirited, he grew morose and sullen, directly in proportion to AAPL's price appreciation. He loved those AAPL shares, and could feel them slipping away. As AAPL moved inexorably upward -- past $100, $110, and $120 -- his despair deepened. When he traded in his iPhone for a Samsung Galaxy, he knew he had hit rock bottom.

On February 19, with AAPL trading over $128, Ian pulled himself together and made his move. He:

- Closed his call for $33.90, and

- Immediately sold his shares for $128.74.

The net cost of these two trades was $.16 per share: $33.90 minus $33.74 in recouped "lost upside" (i.e. the difference between $128.74 and the $95 strike price, money that otherwise would have been forfeited).
By accelerating option expiration (from April 17 to February 19), he increased his cumulative annualized yield from 20.28% to 21.68%.

Moreover, he freed up about $47,400 for immediate reinvestment!

The example from my portfolio involves 100 shares of Valero (VLO), which I purchased in June 2014 for $51.27 per share. I sold or rolled calls on those shares three times, with the last call expiring March 20, 2015 with a $52.50 strike price.

With VLO selling at over $60 on February 19 I decided to exit this position.

I closed the call for $8.15 and immediately sold the shares for $60.40, or $7.90 above my strike price, thus costing me $.25 per share ($8.15 - $7.90). By accelerating option expiration from March 20 to February 19, I increased my cumulative annualized yield from 15.5% to 16.19% (even with the additional $.25 per share cost) and freed up $5,200 for immediate reinvestment.

Assessing the Impact

The ultimate impact of this maneuver on your portfolio depends on how you deploy the proceeds of closing a position. There are three possible scenarios:

1. Don't reinvest. If you choose to keep the money on the sidelines rather than reinvest, you will be the same position that you would have been in had you let the option expire, less what you paid to close the position. You'll take a very small loss, but will have invalidated the reason for closing the position in the first place.

2. Reinvest profitably - good job.

3. Reinvest at a loss - you'll wish you had let the position expire.
It's treacherous out there - be careful!
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