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Options Trading: Dangers of Rolling Covered Calls

By  Jun 22, 2012

Topics: Finance & Investing

Most covered call writers know how to roll a covered call to avoid or defer exercise. But this can create unintended losses or even have serious tax consequences.

In rolling a covered call that's approaching the money or has gone in the money, the strategy is straightforward:

1. Close the current call with a "buy to close" order.

2. Open a new covered call expiring later with a "sell to open order. This will produce additional net income due to the later expiration, thus higher time value.

Ideally, if you can close the current position and open another at a later-expiring higher strike, you have two benefits. First, you escape exercise of the original short position while generating extra income. Second, if you can up the strike, you create more potential profits if that call is eventually exercised.

The problem is that some traders will go for that higher strike and willingly pay a little extra to gain the strike increase. If you do this, be sure you know your true adjusted basis in the short call. It's the sale price plus the debit on the roll. Given that the strike is a new one, be sure the difference between the strike and your original basis is in the black; you don't want to roll to set up a net loss.

Also be aware of possible tax consequences. If your original covered call was qualified (meaning close to or out of the money, or in the money by only one strike increment below the closing price of the previous day), you are safe. But when you roll, your new call could be unqualified. This is a potential problem.

If you have owned the underlying less than one year, opening an unqualified covered call freezes the count to the required one-term before long-term treatment kicks in. For example, if you have owned the stock for 10 months when you roll into an unqualified position, if that short call gets exercised four months later, you have a short-term capital gain on the stock. Even though you owned the stock 14 months, the count is tolled. It doesn't start again until the unqualified option is closed.

These are a few of the potential problems to be aware of before you just roll your short calls forward. Always know your true net basis and what you need to create a profit; and be aware of the tax rules and how they affect your trades.