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Covered Call Writing and Holding a Stock Through an Earnings Report

With expiration Friday and earnings season fast approaching our common sense principles (see chapter 8 of my latest book) become even more important. Never sell a covered call option with an upcoming earnings report is a critical BCI rule. But what if  you own a stock and love it!  Hopefully, your admiration for the stock is predicated upon non-emotional reasons and sound fundamental and technical principles, in addition to common sense.  In most cases, we would sell this equity prior to the report and then re-purchase the stock after earnings are announced, assuming, of course, that the security still meets the BCI system criteria. However, what if you really believe in this company and feel that the share price  most likely will continue to appreciate in value? In such a situation, one can own the stock through earnings and then sell an option after earnings are reported and the price settles down. In other words, you can capture the best of both worlds: the share appreciation from a positive earnings report surprise (what we are anticipating) plus the cash generated from the sale of the option. Before I continue with a real-life example, let me again re-state that this is not part of the BCI System. However, it is something I have done in the past. Any time you own a stock through an earnings report there is the likelihood of volatility and the direction can be positive or negative. We refrain from selling the call because we would limit the upside of a positive surprise (by the option strike price) without downside protection, notwithstanding the option premium which could pale in comparison to the potential price decline in the underlying equity if there was a negative surprise.

That being said, there are limited situations wherein I do retain ownership of the stock through earnings, and thereafter sell the call option when the price of the underlying equity settles, as noted. Let’s look a t a real-life example where I used this strategy with positive results. The following is a brief outline of the six key aspects that existed and affected my decision to retain ownership of RVBD through earnings:

  • I bought RVBD and sold the July call
  • I closed the short option position when the stock and option price declined, in preparation to execute an exit strategy (discussed more fully in Chapter 10 of Encyclopedia for Covered Call Writing).
  • I re-sold the same option in the same contract period when RVBD increased in price (“hitting a double” exit strategy)
  • The option expired worthless and the stock was retained prior to the earnings announcement
  • The earnings report positively surprised and the share price accelerated
  • An option was sold on the next higher strike price after the earnings report was published

For purposes of clarity, I have constructed a line chart depicting the aforementioned six key aspects, which are numbered accordingly on the graph, inclusive of a red arrow indicating the execution of each trade that was effected. Please review this chart and the explanation that follows (trading commissions not included but should be non-events):

Before and after the earnings report

The following numbers reference the numbers shown in the chart:

1- Initial covered call trade:

  • Buy 500 x RVBD @ $29.80 (cost basis = $14,900)
  • Sell 5 x July $30 calls @ $1.53 (initial profit = $765)
  • Initial return = $765/$14,900 = 5.1%

2- Close short call position (buy-to-close):

  • B-T-C 5 x July $30 @ $0.20
  • Creates a debit of $100

3- Re-sell the same call in the same contract month:

  • S-T-O 5 x July $30 @ $0.65
  • Creates a credit of $325
  • Exit strategy (2 and 3, I call “hitting a double”) credit = $225 ($325 – $100)
  • Total profit to date = $765 + $225 = $990

4- Stock price closes below the $30 strike on expiration Friday:

  • Option expires worthless allowing the stock to be retained
  • one-month profit = 6.4% ($990/$14,900)

5- Earnings report is announced:

  • On July 22nd the earnings report is made public
  • The market reacts favorably to a positive earnings surprise (I’m a genius….this time!)

6- Sell the next month call option at a higher strike price:

  • The stock appreciates to near $35 per share and the slightly O-T-M $35 call is sold for $1.35
  • S-T-O 5 x August $35 calls @ $1.35 = $675
  • I compute my returns based on share value at that point in time: $675/$17,400 = 3.9%
  • At the time this chapter was written, the price of RVBD = $36.80, making the stock worth $35 per share (to me) due to the option obligation

For the fun of it:

Although this contract cycle was far from over as this article was being formatted, let’s compute our returns to date starting with the first covered call sale:

Profit:

$765- initial option profit for the July contracts

$225- net credit for “hitting a double” (exit strategy discussed later in the book) with the July $30 calls

$675- initial option profit for the August contracts

$2600- share appreciation from $29.80 to $35 for 500 shares

Total profit = $4265

Initial investment = $14,900

2-month return = 28.6% ($4265/$14,900)…I’m not even going to annualize that!

Conclusion:

The foregoing example was provided primarily in response to the myriad of inquiries I have received in connection with retaining a favored equity through an earnings report. Although this strategy is not part of the BCI system for selling covered call options, I do occasionally utilize same, (especially in bull markets) as detailed above. Bear in mind, however, that the positive results yielded in above-referenced example are not guaranteed. Had earnings disappointed, we’d be looking for a box of Kleenex! The main point here is to be prepared; holding a stock through an earnings report is for investors with a higher risk tolerance and works best in bull market environments.

Market tone:

This week’s reports pointed to a strengthening of our economy:

  • Consumer borrowing rose about 10% in November, the largest increase since October, 2001
  • Retail sales rose by 0.1% in December, the slowest increase since May but an increase nonetheless
  • Business inventories (a measure of change in GDP) rose 0.3% in November
  • The trade deficit widened but reflected stronger consumer demand and business restocking
  • The Beige book Report showed strengthening job growth and production in ALL regions from late November to the end of December

For the week, the S&P 500 rose by 0.9% for a year-to-date return of 2.6%, including dividends.

Summary:

IBD: Confirmed uptrend.

BCI: Cautiously bullish beginning to utilize a small percentage of OTM strikes.

Wishing you the best in investing,

Alan (alan@thebluecollarinvestor.com)

 

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

33 Responses to “Covered Call Writing and Holding a Stock Through an Earnings Report”

  1. Fran January 14, 2012 10:06 am #

    Alan,

    Do you have any specific guidelines you use to keep a stock through an earnings report? Thanks as always.

    Fran

  2. Rob January 14, 2012 2:00 pm #

    If the report is negative and price moves down do you sell the stock or keep it and write a call at a lower strike price? Thanks.

    Rob

  3. Barry B January 14, 2012 5:23 pm #

    Premium Members,

    The Weekly Report for 01-13-12 has been uploaded to the Premium Member website and is available for download.

    Best,

    Barry and The BCI Team

  4. FrankK January 14, 2012 9:15 pm #

    This week would you write 1 week calls or ‘February calls

    I just had a call pulled Friday it was in the money a few dollars with no dividend due does this happen very often? That’s a week early.

  5. admin January 15, 2012 8:26 am #

    Fran (#1),

    There are no specific guidelines I use when
    I hold a stock through an earnings report and I do this only rarely in my covered call portfolio. However, there are certain equities that tend to underestimate in their guidance and positively surprise a high percentage of the time. CSCO was like this many years ago and APPL more recently. The risk is that these companies can have a great report but not meet market consensus and get hammered. It more depends on your personal risk-tolerance.

    Alan

  6. admin January 15, 2012 1:02 pm #

    Rob (#2),

    In my response to Fran (#5), I alluded to the fact that a negative surprise could be the result of a great report not meeting consensus. The company can still be generating profit and revenue in an impressive manner. In this case I might manage my position as I described in a recent article:

    http://www.thebluecollarinvestor.com/blog/covered-call-writing-managing-stocks-that-have-gapped-down/

    If the report showed a change in financial strength or negative guidance, I will exchange it for a stronger financial warrior.

    In general, I use the same screens depicted in the BCI methodology as I share with our community when making my covered call decisions.

    Alan

  7. admin January 15, 2012 4:36 pm #

    Frank (#4),

    1- Calls with 1 week remaining rarely will generate a significant return and you would more than likely be limited to ATM strikes. Given your two choices, my preference would be the February calls. Be careful to check earnings report dates as many of our premium list stocks report during the February contract.

    2- The second part of your question is especially interesting and I thank you for sharing it with us. Early exercise rarely makes sense except in the one instance of capturing a dividend. In your question you eliminated this as a reason. Any other reason for early exercise would be grasping at straws and would be situations that rarely come up but I’ll give it a try:

    1- An inexperienced trader sees a stock price rising and feels that by exercising early and selling the stock he can benefit from that appreciation. The OCC randomly distributes that exercise to a brokerage which then randomly distributes it to one of its customers. Voila, you are the proud recipient of a bad trade on the holders part (but not at all bad for us unless tax consequences were an issue). The option holder would have been better off selling the option and thereby NOT losing the time value of the premium and not having to undertake the risk of share ownership. Remember, I’m grasping.

    2- A professional trader may exercise a deep ITM call option and then sell the stock as a way of hedging within his portfolio.

    3- In very rare instances a deep, deep ITM call option’s bid will be trading below parity. In this case it may be better to exercise and immediately sell the equity than it would be to sell the option. Let’s say the $30 call’s bid is trading @ $9.75 and the stock is trading @ $40. The call can be sold for $9.75 or the option exercised and the stock sold for a profit of $10. This is really rare. Okay, I’m done grasping.

    Alan

  8. FrankK January 15, 2012 6:31 pm #

    Thank you Alan for the detailed answer to my questions. The strangest part of it was that I got an automatic notice form TDA that I have to have enough money in the account to cover the trade! It must be so infrequent that there system assumed I was getting the stock not giving it up.

  9. Hud January 15, 2012 7:49 pm #

    Hi Alan,
    As always, this blog is very educational.
    I have a question about the weekly watchlist. I noticed that NUAN is bold this week. As a matter of habit I plugged it into shatckcharts.com to see the indicators. It looks, to me, that all the indicators are very high. Aren’t the bold stocks in the report supposed to match the buy indicators as explained in your book? In this case the STO (fast and slow) are above 80.
    As always, I look for your insightful response!
    HUD

  10. admin January 16, 2012 8:01 am #

    Hi Hud,

    I’m glad you brought this up because some investors consider a break above 80% a bearish signal for the stochastic oscillator since it is now in “overbought” territory. Although we are always on the lookout for a trend reversal, let me refer you to my books:

    “Cashing in on Covered Calls”

    Page 75:

    “Stocks in strong uptrends can stay overbought for months” and

    “Wait for a negative divergence to develop”

    “Encyclopedia for Covered Call Writing”

    Page 65:

    “Sell signal: %K moves BELOW the 80% for the 2nd time” where %K is the stochastic oscillator, not its moving average (%D).

    Page 67:

    “An ascending stochastic oscillator is also a bullish signal”

    What all this means is that the bearish signal is NOT a breakthrough above 80% but rather a negative divergence or a breakthrough from above to below 80% especially for the 2nd time. NUAN is now showing a rock-solid technical chart, is ranked #13 on the IBD 50, has a Scouter Rating of “10”, has all 6 SmartSelect ratings of “green” and has positive media commentary like from “Seeking Alpha”….”the next Apple” from a performance perspective. I created a chart (below) which shows all the bullish signals confirmed with a rising volume indicator. These are the factors when combined demonstrate why NUAN has earned a “bold” rating from the BCI team.

    Click on the chart to enlarge and use the back arrow to return to this blog.

    Thanks for your generous remarks and keep up the good work.

    Alan

  11. Rob January 16, 2012 5:48 pm #

    Alan,

    When you pick strike prices for ETFs do you use the same rules as for stocks? Examples?

    Thanks.

    Rob

  12. JR January 17, 2012 11:44 am #

    Earnings Report: Not sure if this was discussed before but Yahoo Finance now shows the next earnings reports for stocks. When you view a quote they now give the next earnings date. FYI

    JR

  13. admin January 17, 2012 2:41 pm #

    Rob (#11),

    My general approach to strike price selection is the same as with equities with a few minor differences;

    Our 1-month goals are cut in half going from 2%-4%/month to 1%-2% per month. This is because the implied volatility of ETFs are generally lower than that of individual equities.

    Secondly we are looking at strikes in $1 increments. In the option chain below I have highlighted XHB from our most recent ETF report. At the time of this screenshot, XHB was trading @ $18.47 and I chose the $17, $18, $19 and $20 strikes to feed into the single tab of the Ellman Calculator. The results are shown in the next comment. As always, click on the image to enlarge and use the backarrow to return to this blog.

    Alan

  14. admin January 17, 2012 2:44 pm #

    XHB calculation results shown below:

    Green- initial option return (time value only)

    Yellow- Downside protection, if any

    Pink- Upside potential, if any

    ***Using the calculator will prove to be an incredible tool in guiding us to the best strike selection decisions.

    Alan

  15. Barry B January 17, 2012 3:16 pm #

    JR (#14),

    Thank you for the update.

    Over the years, we have looked at a number of sources that give the ER date. Of all of the sources that we’ve reviewed and used, we chose EarningsWhispers. They have been the most accurate and consistent…they also indicate when the ER date is confirmed. So, we use EarningsWhispers as our “source of truth” for ER dates.

    Best,

    Barry

  16. admin January 18, 2012 8:28 am #

    CELG:

    A stock on our current premium watch list had sales up 22% for 2011 and earnings up 36%. The company gave guidance of the earnings projection to be up 25% in 2012. This would result in a PE ratio of 17.4 x well below its industry average of 28.1. Our premium report shows an industry rank of “A”, a beta of 0.77 with no dividend. The next projected earnings report is on January 26th.

    Alan

  17. Stan January 18, 2012 11:43 am #

    Alan and BCIers,

    Do you have a list of brokerages you recommend for covered call writing? Any suggestions appreciated. Thank you.

    Stan

  18. Benny January 18, 2012 4:57 pm #

    For Stan, I use OptionHouse. Stocks $3.95 and Options are up to 5 for $5.

  19. admin January 18, 2012 8:09 pm #

    Stan,

    In addition to the valuable information provided from Benny, I have sent you a file with additional information regarding online discount brokers.

    Good luck.

    Alan

  20. admin January 19, 2012 7:51 am #

    CELL:

    This small cap company is a new entry to our premium watch list. It is an outsourcer for wireless companies like Apple, Motorola and Samsung. It trades at a reasonable forward PE of 11x. Last quarter CELL reported sales growth of 50% year-over-year and 8% over the previous quarter. Earnings surprised to the upside by 24%. The consensus is earnings growth of 19% for 2011 and 14% for 2012. Share price has outperformed the S&P 500 by 25% over the past year and 9% over the past 30 days. Our premium report shows an industry segment rank of “A” and a relatively high beta of 1.50.

    Alan

  21. Steve Z January 19, 2012 11:12 am #

    Sorry if you’ve answered this recently but as a new premium member looking at my second report, I have a question about the report.

    As I look to place the February trades, there are 27 stocks that are in the running list and don’t have earnings reports. Within that 27, there are only 4 with sufficient Open Interest to trade (ULTA, VFC, CXO, NOG). There are 7 more with marginally enough OI (SHFL, EBIX, ENDP, BGS, maybe OKS, & maybe KOG). This means about 60% of the stocks on the list aren’t tradeable.

    I’m not questioning the fact that there are few on the list this month due to earnings reports. My question/request is whether you could improve the quality/focus of the list by eliminating the ones that really can’t or shouldn’t be traded due to low OI? It seems as though roughly half the stocks could be eliminated with no loss in quality and a heck of a big improvement in usability.

    Or conversely, have I just not understood how to most efficiently use the report?

    Steve

  22. admin January 19, 2012 12:43 pm #

    Hi Steve,

    Thanks for your inquiry and premium membership.

    As an experienced trader you know that OI is constantly changing and heavily news dependent. Since the member must access the options chain anyway, a quick glance at OI and the bid-ask spread would be more meaningful than a posting based on stats @ 4PM EST Friday. On Pg 192 of Encyclopedia … “open Interest of at least 100 contracts and bid-ask spread of $0.30 or less “.

    This is a momentum system, and as such, some traders have a higher risk profile that others and we believe that the selection of stocks to trade is a very individual matter. We want to provide the widest range of stocks so each individual can make decisions that suit their particular situation.

    We are a screening service, not a stock selection service. As Fox News says, “We report, you decide.”

    The stocks on our watch lists have gone through a grueling screening process and as you noted during earnings season, eligible securities decrease in number. We also provide a weekly ETF report that you may find useful.

    As our longer-term members know, we make every effort to respond to the needs and suggestions of our members. We thank you for your suggestion and will keep it in mind going forward as additional levels of membership become available.

    Alan

  23. GDC January 19, 2012 12:44 pm #

    While it’s a nice problem to have, there has definitely been an opportunity cost this cycle to writing covered calls. I even managed to “hit a double” with AMZN only to see it really break out to the upside over the past few days.

    I still love the strategy though…

  24. deano January 19, 2012 3:12 pm #

    I have not had much luck using the show or fill rule to my advantage in my CBOE paper trade account. Does show or fill work in a paper trade account?

    Thanks,

    deano

  25. admin January 19, 2012 4:10 pm #

    GDC,

    Congrats on the double…I love it!

    Alan

  26. admin January 19, 2012 4:15 pm #

    Deano,

    Most market makers use “electronic eyes” to monitor their trades and I know of no “paper-trading system” that uses this technology. My assumption then is that they use only the published bid-ask spread. It will work a good percentage of the time in real trading when done properly. I spoke to an options trader at the CBOE who couldn’t think of a paper-trading system that had this capability. If any of our members have any knowledge of such a capability please let us know. I will follow up if I get additional information on this.

    Alan

  27. admin January 19, 2012 4:44 pm #

    GOOG and oh those ERs:

    Google reported a strong earnings report BUT it didn’t meet market expectations and the share price is taking a real hit, down $58 at the time of this post:

    http://www.nytimes.com/2012/01/20/technology/googles-strong-results-less-than-expected.html?_r=1&partner=yahoofinance

    Alan

  28. GDC January 19, 2012 7:08 pm #

    I had owned GOOG for awhile, but sold it two weeks ago after watching a Fast Money segment, of all things, and to make room in the portfolio for more suitable covered call candidates.

    Your blog post is certainly apt.

  29. admin January 19, 2012 7:12 pm #

    Premium members:

    This week’s 6-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site.

    For your convenience, here is the link to login to the premium site:

    http://www.thebluecollarinvestor.com/member/login.php

    Not a premium member? Check out this link:

    http://www.thebluecollarinvestor.com/membership.shtml

    Alan and the BCI team

  30. Fred January 20, 2012 7:05 am #

    Alan,

    Are you planning to have your books available for Nooks in the future?

    Fred

  31. admin January 20, 2012 11:34 am #

    Fred,

    My books actually just went up in Nook format this week. I’ll get the links and post in this week’s blog article. Thanks for your interest.

    Alan

  32. Steve Z January 20, 2012 6:11 pm #

    I’ve read this month’s article a couple of times and have a question.

    The reason to not hold through earnings is we don’t know which direction the stock might go and that’s not good for conservative investors. This makes sense to me.

    However, once one decides to hold through earnings, since selling a call is actually a way to mitigate downside risk, it seems like this would be the more prudent conservative strategy to use rather than letting the stock stand “naked”.

  33. admin January 20, 2012 7:01 pm #

    Steve,

    First let me re-iterate that owning a stock through an earnings report is not part of the BCI methodology. However, many of our members (including me) will choose to hold a stock through these reports from time to time and so I feel obligated to address this issue in my books, DVDs and seminars.

    As you know, covered call writing is a strategy that attracts conservative investors. Much of the BCI methodology is designed to improve the prospects of successful returns and achieving the highest possible results. That’s the case with the rule of avoiding earnings reports.

    Let’s say that historically a stock trading @ $38 will trade in a $2 range either way between $36 and $40 in a 20-25day period. Selling the $40 call @ $2 is manageable and will more often than not result in a handsome monthly return. Now, let’s fast forward to the month of an ER. The IV volatility will rise because a bad miss or a positive surprise could result in an $8 move in either direction. With a call our upside is limited to $40 but the downside is not protected to that extent. Yes the breakeven is $36 but since most surprises of these “favored” companies (why are we holding the stock through the ER to begin with…we love the prospects and historically the company surprises on the upside) are to the upside. So if you do not limit the upside at these times with a call in the long run you will generate much higher returns. The “odds” are with us.

    Most of our members know that last night GOOG had a great ER but disappointed and was down $58 today. In the past year, it disappointed twice and positively surprised twice (see the chart below). Let’s say our favored stocks have this 50% batting average. If we limit upside with a call prior to the report with no protection of a disappointment , we lose. I know first hand because it took me a while to figure this out when I first started educating myself in this great strategy. I don’t want our members taking those same hits.

    Let me emphasize that in my cc writng portfolio I rarely will own a stock through an ER. Many years ago, I held CSCO through ERs because it had an incredible streak of positively surprising. More recently I have done this with AAPL.

    Alan

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