Rolling Forward Call Options

There is a stock option technique used in some situations that can allow you to buy more time when call options you own are going to expire called rolling forward.  The other day, I happened to engage in this practice when reviewing the funds held in a trust account for my retirement over which I am the beneficiary.  I thought it might be useful to explain what I did and the reasons behind my actions.

Please note: I would never under any condition recommend the positions I’m about to discuss for anyone to purchase in their own accounts.  They may very well lose every penny and go to a total and complete loss.  The purpose is to illustrate a concept to help you understand finance and the markets better.  You have been warned!

The Background: The Purchase of the Original General Electric Shares and Stock Options

During the Great Recession, many of you know I was excited about shares of General Electric common stock.  I was interested in GE when it fell from $40 to $22.  When it went to $6, I was nearly doing cartwheels around the office to the point that every day, my own grandmother inquired as to the price change of General Electric when the New York Stock Exchange closed.  It became part of the daily conversations because I was convinced that I wouldn’t get a chance to buy a blue chip stock of that caliber at that price very many times in my life.

It has been a more than satisfactory experience and, despite selling off some of our profits thus far, we still own plain vanilla common stock in the firm bought at very low prices.  In my own case, I have shares that I hope to own forever through my personal retirement accounts, which I can’t touch for at least another 30 years.  When, and if, the dividend payout is returned to the level of a few years ago, my cash dividend yield on cost will be enormous – something like 23% – and because it is in accounts that are locked away, not a penny in taxes will be owed on them.  Even if it take 7 or 8 years, that is one hell of a deal so I don’t care what the shares do (and, like I said, I can’t access the money or withdrawal it until I am almost 60 years old, anyway, so the long-term horizon is the only rational approach here).

As such, the overall investment was fantastic.  It was the sort of thing that makes your year.  But there were two trades in particular that had not yet been successful because they were the riskiest positions in the entire portfolio.  I did it through a trust account that I manage that holds more aggressive securities including speculative call options on GE common stock.  I’m going to show you how this trust fund used rolling forward as a strategy in the hope that it will make the concept easier to understand.

The Trust Makes Its First GE Call Option Purchase in May 2009

The first transaction was on May 19th of 2009.  The trust paid $10,781.70 to acquire the right to buy 4,100 shares of General Electric at $15 per share any time between that date and January 22nd, 2011.  The stock closed that day at $13.96.  That means that after commissions, the price paid for the options were $2.63 per share. Here is a copy of the trade confirmation from Charles Schwab & Co., where the trust is administered.

Obviously, since General Electric was trading at $13.96, the option itself had no intrinsic value because who would pay $15 for the stock when you could just buy it for the lower price on the stock exchange?  That means that the entire $2.63 represented time value.  It was a gamble on the future direction of General Electric stock and, more dangerously, the time frame in which the stock would increase.

• Loss: If by the expiration date, GE was $15 per share or below, the stock options would expire worthless.  It would be a total and complete loss.
• Partial Recovery to Break Even: If by the expiration date, GE was trading between $15 and $17.63 (which is $15 strike + $2.63 cost), the trust would recover some of its money.  For example, the true break even point is $17.63, so if the stock were $16.25, the loss would be $1.38 per share because $17.63 – $16.25 = $1.38.  Since we are talking about 4,100 shares, that would be a total loss of $5,658 on a $10,781.70 gamble.  Even though GE had gone up from $13.96 to $16.25, a rise of 16.4%, the trust would have lost 47.5% of its speculation!
• Profit: If the price of GE was over $17.63, every additional rise of $1 in the stock price would equal a profit of $4,100 on the call options.  So, if GE had gone to $20.00 per share, the trust would exercise its option to buy the stock at $15, sell the shares for $20, and pocket the $5 difference.  Since $2.63 was our cost, the gain would be $2.37 per share, or $9,717.  The options turned a 43.27% rise in stock price into a 90%+ gain.  (The effects are even bigger if the stock skyrocketed to, say, $30 per share in which case the options would have generated a profit of $50,718.30 for the trust plus it would get its $10,781.70 investment back for a total of $61,500.)

The Trust Makes Its Second Purchase of GE Call Options in October 2009

The second transaction involving this particular series of GE call options was made on October 14th, 2009.  It involved the acquisition of 27 contracts, covering 2,700 shares, of GE common stock for $3.60 per share.  The total price of these options came to $9,749.20 after commissions.  On that date, the underlying GE common stock closed at $16.84 per share.  Here is a copy of the trust’s trade confirmation:

That means that this time around, the call options already had some intrinsic value.  You could immediately exercise the option to buy at $15 per share and sell the stock on the open market for $16.84, pocketing a $1.84 profit ($16.84 – $15 = $1.84).  However, since buying that right cost $3.61 per share, you would still have a loss were you to do that because $3.61 cost – $1.84 profit = $1.77 loss.

That means that $1.77 of the GE call options represented time value.  It also meant that the break even point for these options was $18.61 per share ($15 strike + $3.61 cost = $18.61).  Anything above that was significant gain, anything below it was a loss, and anything below $15 strike was a complete wipe out.

The Combined Position

The net result of these two transactions was 68 contracts covering 6,800 shares of GE common stock at a strike price of $15 with an option cost of $3.02, resulting in a break even point of $18.02 across the portfolio.  The trust had paid $20,530.90 in cash to buy these rights.  Now, it had 1 year and 2 months to hope that General Electric recovered to the same degree Wells Fargo & Company and U.S. Bancorp already had.

Over the subsequent year, the position fluctuated in value insanely (remember, stock options are a form of leverage).  It hit a high of almost $40,000 and then crashed to a low of almost $8,000 within a matter of weeks.

Rolling Forward the Call Options

As we got closer and closer to the January 22nd, 2011 expiration date, the time value of the options began to decay more and more rapidly.  After all, with less time remaining for the options to turn out in your favor, why would someone be willing to pay as much for them?

Then, an interesting thing happened.  The price of the January 2011 call options with a $15 strike exceeded the price of the January 2012 options with a $17.50 strike.  That means, if I wanted the trust to have more time with the gamble, I could buy a whole extra year of time in exchange for bumping the strike up an extra $2.50.  Because of where GE stock happened to fall – above $15 per share – I could have the trust buy more of the 2012 options, making up for the increase strike by acquiring a greater amount of absolute contracts.

I decided that I wanted the trust to have more time with these GE options.  The order was given to Schwab as follows:

• The trust liquidated the 68 contracts, or 6,800 options, and the trust received $13,539.91 in cash.  This locked in a realized loss of $6,990.99 ($20,530.90 paid – $13,539.91 cash received = $6,990.99 loss).
• The trust, within seconds of the previous transaction, bought 78 contracts covering 7,800 shares of GE, with a $17.50 strike price expiring on January 21, 2012 (an extra year in the future), paying a total of $13,718.03.

An Analysis of the Stock Option Rollover Position

This resulted in a built-in loss of roughly 90 cents for the “new” options that must be taken into account to regain the money from the 2011 series options that were sold.  ($6,990.99 loss on old position / 7,800 shares = $0.90 per share on new series of options).

We know that the price paid per option after commissions is $13,718.03 / 7,800 shares = $1.76 so we would add the 90 cent loss to it for a total of $2.66.  We add this to the strike price of $17.50 for a grand total of $20.16.

In practical terms, that means that the trust now has an entire extra year to watch General Electric increase in price (or, decrease in price in the event of another market crash which is where the risk originates), and if GE shares reach $20.16 it will regain all of the money on the original transaction and be back to the starting $20,530.90.

Anything above $20.16 will result in a gain.  Since the trust controls 7,800 shares of GE, every $1 gain above that threshold would result in a $7,800 profit.  If GE went to $30 per share, the profit would be $76,762 plus the $20,530.90 was recaptured for total liquidation value of $97,282.90.  If GE is trading below $20.16 by January of 2012, a loss would be incurred.  If it is trading below $17.50 by January of 2012, it is a total complete loss.

The leverage inherent in the use of stock options and the stock option rolling forward technique means that the difference between GE at $17 and GE at $30 is the difference between a total loss (literally, $0 in value for the trust) or nearly $100,000 in cash.

Don’t Forget About Time Value!

This is important: You cannot forget the time value!  It is a nice bonus.  If GE were to go to, say, $18 per share tomorrow, it is highly likely that there is so much time value left now that the trust is holding calls that don’t expire until 2012, that the options would be trading at well over the equivalent of the $20.16 break even point.

Likewise, if GE were to go to $20.16 tomorrow, the intrinsic value would be at break even but there is still a ton of time value remaining.  That means the trust could actually sell the entire position at a profit of (I’d guess) $16,000 or more.  For the sake of conservatism (which is an oxymoron in some respects when dealing with speculation), I ignore all time value and consider any of it gravy; a nice gift from the market that can drop to the bottom line.

A Word on Stock Options

In most all cases, stock options are not appropriate for conservative investment and, in fact, fall soundly within the domain of speculation.  But, as Benjamin Graham said, just because speculation is risky doesn’t mean you can’t have intelligent speculation.  You just have to realize that what you are doing is nothing more than a glorified form of gambling that promises no safety of return.

That is the reason that any speculation should be done in self-contained accounts with money you don’t need and only after you sufficient emergency reserves, no credit card debt, you own your car outright, your retirement accounts are fully funded, so on and so forth.  In the case of certain types of stock option transactions, total 100% wipe-out losses are a very real possibility.

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3. Stock Dividends Are Not Income – They Are a Balance Sheet Reclassification for Accounting Purposes
4. Today’s Market Is an Example of the Reason I am a Value Investor