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Daily Options Survey
The Weekly Option Strategist, August 11, 2011

Model Portfolio Update: Rolling Down and Out

With the recent sharp decline in the stock market, we need to roll 16 of the 20 short call positions in our portfolio to lower strike prices and/or to later expirations.  The bad news, of course, is that the portfolio is down since quite a bit since we last rolled our positions (on 7/13/2011).  The good news is that we are better off than the S&P 500 and the other benchmarks. Also in the good news category are the profits and the rich new premiums we are taking from rolling the calls. After adjustments this time, the portfolio has the following reward/risk profile; per annum yield 26.9%, downside protection 8.0%, and maximum profit potential 9.5%.

Performance and Guidelines

In Figure 1 below, we show the performance of our Model Covered Call Portfolio from 7/13/2011, which was the prior time we adjusted our positions, to 8/11/2011 (at 10:00 A.M.), when we rolled 16 of the 20 short call positions in the portfolio.  

Model Portfolio Update 09-09-11 Figure 1 

As can be seen from the above, our covered calls lost 3.3% less than our underlying stocks (9.3% versus 12.6%) and 3.6% less than the S&P 500 (9.3% versus 12.9%) over the period.  Had we followed our own guideline one week earlier, and rolled many of our calls whose downside protection had already gone below 2%, our losses would have been considerably less. The “lesson learned” is that while it is best to not overtrade covered calls, one needs to respond to major movements in a timely fashion. Stated more simply, in volatile markets, one should trade more often.

Our Rolling Transactions

In Figure 2 below, we show the show the results of our rollover transactions in which we have bought our 16 outstanding call writes and written new ones on the same stocks.  We are assuming that we have placed these as normal market spread orders.
For example to roll our call position in Alcoa, we would place the following order; buy 40 Alcoa October $18 calls (ticker: AA    111022C00018000) to close and sell 40 Alcoa October $11 calls (ticker: AA    111022C00012000 ) to open.  Usually, one should a place a realistic price limit on these orders.  In this case, we are rolling down from a lower premium call to one with a higher premium; therefore, we would specify a credit level equal to, or better than, the difference between the net premium shown, in this case $1.02.

Model Portfolio Update 09-09-11 Figure 2    

Our New Positions

One nice thing about taking a reasonably dynamic approach to covered calls writing is that in the face of market turmoil, one can take advantage of high premiums levels.  In Figure 3 on page 3, we show the portfolio after having made our adjustments. Before we rolled our 16 calls, the portfolio showed the following reward/risk profile; per annum yield 15.3%, downside protection 2.2%, and maximum profit potential 16.4%.  After making our adjustments, this was the profile; adjustments this time, the portfolio has the following reward/risk profile; per annum yield 26.9%, downside protection 8.0%, and maximum profit potential 9.5%. Obviously, we have given up some of the upside by rolling the calls down, but we have managed to capture some attractive premiums in the process.

Model Portfolio Update 09-09-11 Figure 3

Prepared by Lawrence D. Cavanagh vloptions@valueline.com

At the time of this writing, the analyst had no positions in any o the stocks mentioned above.