# Rolling Up/Over vs Getting Exercised



## bucket183 (21 August 2009)

I am a newbie to the options game. I am in the options game for cashflow and cashflow only, so I don't really care about the underlying stock.

I am wondering why someone would roll up/over vs being exercised.

Example
I buy share XYZ for $1.46 and write a call for $1.50 ($0.10 premium). The price goes up to $1.60 (the first price that I could likely to be exercised, right??). I decide to Roll up to $1.70, so I buy back the original call for $0.17 (probably??) and write a new call for $0.06. So I costs me $0.11 to keep the $0.14 Capital Growth. So I sacrifise my $0.11 cashflow for the Capital gain (less two lots of brokeage)

If I get exercised then I recieve the $0.04 cashflow (less one lot brokeage). Then I have the option to rebuy share XYZ or move onto something else.

Am I looking at this the wrong way or is there something I am missing???


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## cutz (21 August 2009)

Hi Bucket183,

Since you don't care about the underlying and options are for cashflow only and  
you are doing a covered call because you are confident the stock won't tank why not just write an ATM naked put, same strike as your proposed covered call.

Disclaimer>> not something i would do.


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## Toothyfish (21 August 2009)

Hi Bucket,
Another possible reason for holding onto the underlying >12 months is to reduce capital gains tax. 
However, if the underlying stock plummets, tax will be the last thing you have to worry about.


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## sails (22 August 2009)

bucket183 said:


> I am a newbie to the options game. I am in the options game for cashflow and cashflow only, so I don't really care about the underlying stock.
> 
> I am wondering why someone would roll up/over vs being exercised.
> 
> ...




Hi Bucket- I think it depends on a couple of things.  One is broker fees.  Sometimes it can be so expensive to do the stock transaction that it simply is better to roll.  I don't know if Commsec still charge it, but at one stage is was about .3 something percent for the underlying stock transaction. Let's say the underlying is valued at $200,000 - that's at least $600 in stock fees (one way).  Do that twice (once to sell the stock and then buy it back to set up a new position) and it can become a huge expense.

The other thing is if are you are considered a trader or an investor for tax purposes.  It you qualify as a trader, then I believe you won't be up for capital gains tax - but if you fall into the category of investor and then be up for cap gains tax as Toothyfish has pointed out - thus favouring rolling instead.

Dividends and other underlying corporate events can also be a reason to exercise or not.

Cutz has a point - there is the same downside risk in a covered call as there is in a naked put and only one transaction to put it on.


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## bucket183 (22 August 2009)

I have been thinking about the naked put over night. Obviously I like the idea of the larger cashflow gain (compared to covered calls) but does'n't that imply a larger risk???
From what I have seen the ATM Put is worth generally over twice as much as the call but if you get exercised isn't it going to cost a whole lot more than a covered call???


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## sails (22 August 2009)

bucket183 said:


> I have been thinking about the naked put over night. Obviously I like the idea of the larger cashflow gain (compared to covered calls) but does'n't that imply a larger risk???
> From what I have seen the ATM Put is worth generally over twice as much as the call but if you get exercised isn't it going to cost a whole lot more than a covered call???




As long as it is the same quantity, technically the downside risk is the same.  You would lose money from your stock position in a covered call if the market tanks, just as you would lose money on the naked put.  While the risk is similar, there are two separate issues when comparing covered calls with naked puts as management of the position (including assignment risk) has differences.  

Also,  the "cost-of-carry" on the stock is often an overlooked expense in covered calls.  The cost-of-carry depends on how much it costs you in interest to hold the stock position day after day, or alternatively, how much interest you are forfeiting by not having the funds in your bank account.  For this reason, normally puts are a bit cheaper than calls - see my next paragraph.

Just one query - you mention that the ATM puts are much more expensive than the calls.  Are you deducting intrinsic value so you are comparing only extrinsic value in the options?  Or are there dividends coming up on the underlying stock?

One strategy that is bandied around starts with naked puts and then the plan is to keep writing them month after month until assigned.  Then keep the assigned stock and start writing calls over that stock until the sold call gets assigned.  Then go back to writing puts again.  Rinse and repeat!  Now, before that gets taken as a free money strategy - sadly that is not necessarily so due to the downside risk in both strategies.  As has been said before - naked puts/covered calls is eating like a bird and ....... like an elephant.  lol - says it all really.


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## bucket183 (22 August 2009)

Sails,

Thanks for info (I am not sure about your last statement) as I said I am new to this (ie one month new). In my previous post I was going to use ANZ as an example about the Puts being more expensive but I was proven wrong, they were similar prices.

I understand that the risk is the same for a covered call vs naked put (hence the similar prices but I guess what my "gut" factoring in is that I don't mind losing share captial if the stock price goes down as I'll just keep writing calls. But in the nake puts case, I don't feel so good about buying shares to cover the put (once exercised) at the higher price when they have gone down.

I guess though in this sideways or slowly going up market the "chances" of being exercised on the Put are much less than 12months ago.

What stategy do you use when it comes to nake Puts??


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## NeuromanceR (22 August 2009)

bucket183 said:


> I don't feel so good about buying shares to cover the put (once exercised) at the higher price when they have gone down.




No need to go naked. Buy a protective put(s) and the position will become a 'bull put credit spread'.


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## sails (22 August 2009)

bucket183 said:


> Sails,
> 
> Thanks for info (I am not sure about your last statement) as I said I am new to this (ie one month new). In my previous post I was going to use ANZ as an example about the Puts being more expensive but I was proven wrong, they were similar prices.
> 
> ...




Bucket183 - I don't use covered calls or naked puts as there are many other option strategies which don't require stock and where it is easier to manage risk. Any strategies I use are very much dictated by volatility conditions. I started with covered calls when I first began options trading and actually locked in quite a large loss by continuing to write calls (as I had been taught!) when the market was on it's lows. Consequently, I found it necessary to get market direction right with covered calls - eg. to know when to write calls and when to hold off and let the stock run to the upside.   The sold calls severely capped the gains I so badly needed to get the money back on stock that had tanked.  Oh, and for the record, I'm not taking any short term trades at the moment - have other family issues which are taking up an enormous amount of my time.  Really miss it though and looking forward to getting back to it as soon as possible.

I have put a bold font on your statement above where you state you don't feel so good about buying shares at the higher put price when the market is down.  Think about it - that is the price you would have paid for your stock if you had a covered call on instead of the naked put.  There is a risk of losing significant money on the stock position should the market tank - just as it would with naked puts.

So, why would you feel any differently - your stock position would have the same loss whether you bought the stock originally at that price, or whether your put is assigned at exactly the same price?

OK, I'll rephrase my last statement with an example.  Say you might pick up a tiny 10c per month (and that's IF you can actually average that each month) and then the stock loses a $1.  That's 10 months of "income" gone on the stock loss.  The 10c is the analogy of eating like a bird...


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## sails (22 August 2009)

NeuromanceR said:


> No need to go naked. Buy a protective put(s) and the position will become a 'bull put credit spread'.





Absolutely - and the protective put can also be added to the covered call position - turning it into a synthetic bull call debit spread.  If done at the same strikes/month as the bull put credit spread, it will (under normal circumstances) return the same profit or loss result.


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## bucket183 (22 August 2009)

Sails,
Understand what you are saying, I guess I feel that way because if if the stock tanks

Covered Call, I still have the premium and the underlying stock (albeit worth less)

Naked Put, I have the premium and have to buy stock (cheaper stock) to cover the exercise.

So in terms of cashflow, would I be far worse off in the nake put case??


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## wayneL (22 August 2009)

NeuromanceR said:


> No need to go naked. Buy a protective put(s) and the position will become a 'bull put credit spread'.



Bear in mind, that in removing one risk, it inevitably shows up as a different risk somewhere else...

...even if it's opportunity risk.


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## wayneL (22 August 2009)

bucket183 said:


> Sails,
> Understand what you are saying, I guess I feel that way because if if the stock tanks
> 
> Covered Call, I still have the premium and the underlying stock (albeit worth less)
> ...




No.

What Sails is telling you is that they are synthetically equivalent. That means the risk and reward are the same.

I'm a little confused by what you mean by "cashflow". In terms of cashflow as I understand it, this has nothing to do with bottom line. 

If you mean capital usage, the put requires less if you have a margin account, but the same in a cash account

If you mean bottom line profit, both are equivalent, just different mechanics in getting there.


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## sails (22 August 2009)

bucket183 said:


> Sails,
> Understand what you are saying, I guess I feel that way because if if the stock tanks
> 
> Covered Call, I still have the premium and the underlying stock (albeit worth less)
> ...




Maybe an example would help.  Lets use your $1.46 stock.

Covered Call:
*Buy the stock @ $1.46
*Sell the $1.50 strike call for 10c premium.
*At expiry, stock is trading at $1.00 and call expires worthless.
- loss on stock is 46c less premium earned = 36c net loss on position.

Naked Put:
*Sell the $1.50 put for 14 cents 
_(4 cents of intrinsic = 10c of extrinsic so it's the same as the call. 
For simplicity's sake, this purely hypothetical premium does not include cost of carry)_
*At expiry stock is trading at $1.00.  
* Put is assigned, so buy stock at $1.50 - $1.00 = 50c less premium of 14c =  36c net loss on position.

Where is the difference in cash flow?

BTW, I'm not trying to knock your new found strategy!  Having started out with option seminars a few years ago, my personal experience has been that not all the facts are taught.  The risks in a position such as covered calls is often glossed over.  As I said in a previous post, I learned some pretty painful lessons along the way and so I simply try to pass on what is not taught to give new comers a better chance of survival in the option jungle.


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## bucket183 (22 August 2009)

Sails,
Thanks for the example. Makes a lot of sense. I guess what I mean by cashflow is actual cash in hand so in the call case the loss that is incurred doesn't come out of actual cash in my bank account. Whereas in the put case I have to take money from my account to pay for the shares. I guess it is an overly simplistic way of looking at it, but that is my gut feeling.


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## wayneL (22 August 2009)

bucket183 said:


> Sails,
> Thanks for the example. Makes a lot of sense. I guess what I mean by cashflow is actual cash in hand so in the call case the loss that is incurred doesn't come out of actual cash in my bank account. Whereas in the put case I have to take money from my account to pay for the shares. I guess it is an overly simplistic way of looking at it, but that is my gut feeling.




It's still real money whether it's cash in the bank or the value of your shares.

Also bear in mind that you don't have to wait to be assigned, you can trade out of either option once extrinsic value becomes negligible.

There are many management options, depending on what you are trying to achieve.


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## bucket183 (22 August 2009)

Thanks WayneL, 
Just adding to what I said before, in the call case I have always got the option of keeping the shares and hopefully making my money back later (as the market improves) whereas in the put case I am simply outlaying cash for shares for someone else to make up that position later.


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## wayneL (22 August 2009)

bucket183 said:


> Thanks WayneL,
> Just adding to what I said before, in the call case I have always got the option of keeping the shares and hopefully making my money back later (as the market improves) whereas in the put case I am simply outlaying cash for shares for someone else to make up that position later.




It depends.

If you allow the options to be assigned, you end up with the same share position either way. (and don't forget that synthetic equivalence only applies if the strike price is the same)

If the share price ends up below the strike price:


In the covered call position, your call expires worthless and you keep the shares.
In the naked put position, your put expires in the money and you will be assigned shares.

You end up with shares in both cases.

If the share price ends up above the strike price:


In the covered call position, your call expires in the money and your shares will be called away.
In the naked put position, your put expires out of the money and you just keep the premium.
You end up with *no* shares in both cases.

As sails discussed, the idea here is not to convince anyone to trade one over the other. It's to understand the equivalence so that a decision can be made with full knowledge of the facts.


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## sails (22 August 2009)

bucket183 said:


> Sails,
> Thanks for the example. Makes a lot of sense. I guess what I mean by cashflow is actual cash in hand so in the call case the loss that is incurred doesn't come out of actual cash in my bank account. Whereas in the put case I have to take money from my account to pay for the shares. I guess it is an overly simplistic way of looking at it, but that is my gut feeling.




Unfortunately, feelings don't cut it in options trading.  Facts are more important.

In the case of the example, that fact is that you buy the stock at exactly the same price - $1.46 with both strategies.  The only difference is that one is purchased earlier the other, but the price (and risk) remains the same for both.

This is absolutely not to convince you to trade naked puts - rather to point out that covered calls carry the same downside risk as naked puts.  A fact that is often misunderstood.


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## bucket183 (22 August 2009)

Thanks wayneL & Sails,
I think it has just clicked. Sails what you just said in your last post makes absolute sense. Thanks for clearing it up. 
Have you got any other pearls of wisdom for me???? 

Thanks again.


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## BradK (23 August 2009)

bucket183 said:


> Sails,
> 
> I understand that the risk is the same for a covered call vs naked put (hence the similar prices but I guess what my "gut" factoring in is that I don't mind losing share captial if the stock price goes down as I'll just keep writing calls. But in the nake puts case, I don't feel so good about buying shares to cover the put (once exercised) at the higher price when they have gone down.




That does not make sense Bucket. If you are willing to buy a share to write a covered call over it, why would you not write a naked put?  Exactly the same strategy in reverse. 

If you are committed enough to buy $100,000 worth, why not just write an ATM put (make some cash), then get exercised and buy it, and then write the covered call against it??? 

PS. You ain't listening to a certain 'share renting spruiker' are you? Be careful of the numbers you are being quoted. 

Brad


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## BradK (23 August 2009)

NeuromanceR said:


> No need to go naked. Buy a protective put(s) and the position will become a 'bull put credit spread'.




Yup, the cost of 'insuring' yourself so that you can write covered calls from here until kingdom come - or when the put expires, is basically safe. But, the cost of doing the deal might hurt your overall bottom line. 

Brad


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## BradK (23 August 2009)

sails said:


> Bucket183
> 
> 
> So, why would you feel any differently - your stock position would have the same loss whether you bought the stock originally at that price, or whether your put is assigned at exactly the same price?




My point exactly.


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