Friday, October 12, 2007

Avoid Losing On Stock Options Part 3

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.

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 sold 200
Profit on second call sold 400
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.

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.

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