beginners corner

Covered Call Writing: Generating Additional Income When A Stock Price Gaps Up

Mastering option trading basics includes incorporating exit strategies into our portfolio trades. These opportunities present themselves both when a stock prices declines and accelerates. Recently, a premium member presented me with a hypothetical trade involving FSLR that I felt would be of interest to the entire BCI community. Let me premise my remarks by saying that FSLR is NOT currently on our premium watch list but has been in the past. Here are the particulars and then we will discuss:

  • March 18th: Buy FSLR @ $27.25 and sell the April $28 call for a 3.5% initial, 1-month profit
  • April 9th: Price of FSLR gaps up to $39 and the $28 call option to $11.10
  • The additional share appreciation brings the trade profit to > 6% and is maxed out no matter how high the price goes
  • There is an upcoming earnings report prior to the May expiration

Let’s take a look at the price chart of the stock showing the gap up:

 

Exit strategies for covered call writing
FSLR price gaps up

 

Next, let’s look at the price chart of the April $28 call option demonstrating the corresponding gap up:

Blue Collar Investor exit strategies

FSLR April $28 call option gap up

 

The question posed to me was which of the following actions should we consider?

  • Buy back the $28 call and roll up to a higher strike to benefit from additional share appreciation
  • Since the earnings report negates the choice of rolling out, just allow assignment after expiration Friday
  • Another choice?

Let’s review these choices:

Rolling up in the same month

I generally don’t take this approach because a stock that has gapped up may decline in price due to profit-taking (which it did as of this writing). In addition, we will be incurring an option net debit and thereby depending on further share appreciation to make this approach profitable. Let’s reject rolling up in the same month.

Allow assignment after expiration Friday

An astute observation by this member to avoid the next month earnings report. This is a viable choice if there is none better. A > 6%, 1-month return with protection all the way down to $28 is not a bad deal!

Another choice (notice how I’m avoiding the word “option”)

You know how I love to squeeze every ounce of profit from our trades and we may be able to do so here. Because of our option obligation, our shares are worth $28, not $39. If we close our short options position and buy back the $28 call for $11.10, our shares are now worth market value or $39. Let’s do the math:

$11.10 debit (buying back the option) + $11 credit (share appreciation from $28 to $39) = net debit of $0.10 = $10 per contract.

Since we no longer have an option obligation we can sell our shares for $3900 per contract and put this cash right to work. If we can institute a NEW covered call position in the last 9 trading days of the April cycle which generates more than $10 or four tenths of 1% then we have successfully instituted an exit strategy and created a second income stream in the SAME month with the SAME cash. I call this the mid-contract unwind exit strategy.

 

Link to sign up for my April 2oth seminar in Atlanta:

http://www.meetup.com/Atlanta-Option-Investors-Club/events/113533742/

 

Market tone:

This past week’s economic reports leaned to the negative but the stock market remained strong. The Fed policy makers expressed concern over the impact the sequester may have on our recovery:

  • The Producer Price Index (PPI- a measure of the average change over time in the selling prices of a fixed basket of goods by stage of production, industry, and commodity. It is
    considered a leading indicator for consumer inflation. The “core” PPI excludes food and energy prices—which account for roughly one-quarter of the broad PPI and tend to fluctuate widely—providing a truer reflection of inflationary trends) dropped 0.6% in March (-0.1% expected), the largest 1-month drop since May, 2012. A big component of this decline was due to the 6.8% drop in gasoline prices
  • Initial jobless claims for the week ending April 6th came in at 346,000, less than the 365,000 projected
  • According to the Labor Department retail sales (a report of the dollar value of sales of a broad range of goods, from cars and gasoline to furniture, food services, and clothing. Retail sales are a major indicator of consumer spending trends, accounting for a substantial portion of total consumer spending and aggregate economic activity) in March fell by 0.4% after rising 1% in February
  • The minutes from the March 19-21 FOMC meeting revealed that some policy-makers were concerned over the impact the sequester might have on current monetary policy of quantitative easing where the Fed is buying $85 billion a month in US Treasuries and mortgage-backed securities. The concern relates to possible increases in interest rates and inflation
  • Business inventories increased by 0.1% in February, less than the 0.4% anticipated

For the week, the S&P 500 rose by 2.3%, for a year-to-date return of 12%, including dividends.

Summary:

IBD: Confirmed uptrend

BCI: Moderately bullish but favoring in-the-money strikes until the impact of the sequester is quantified or resolved.

The entire BCI team thanks you for your amazing support.

 

My best to all,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

Tags:

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.

7 Responses to “Covered Call Writing: Generating Additional Income When A Stock Price Gaps Up”

  1. Alan Ellman April 13, 2013 9:44 am #

    Premium members;

    Due to a power outage in South Jersey, some of our team members are unable to work on this week’s stock report. In the past, power has been restored in a reasonable time frame so this is most likely not an issue. I wanted to give you a heads-up in case there is an unusual delay. I’ll keep you updated.

    Alan

  2. Barry B April 13, 2013 12:02 pm #

    Premium Members,

    Power is back! It was out for about two hours…back to the report.

    best,

    Barry

  3. Barry B April 13, 2013 6:54 pm #

    Premium Members,

    This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor premium member site and is available for download in the “Reports” section. Look for the report dated 04-12-13.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:

    http://www.youtube.com/user/BlueCollarInvestor

    Since Earnings Season is about to begin, be sure to read Alan’s article, “Constructing Your Covered Call Portfolio During Earnings Season”. You can access it at:

    http://www.thebluecollarinvestor.com/constructing-your-covered-call-portfolio-during-earnings-season/

    Best,

    Barry and The BCI Team

  4. Vincent April 14, 2013 9:29 am #

    Alan,

    When using this strategy which type of strike price do you favor if any?

    Thank you.

    Vincent

    • Alan Ellman April 15, 2013 7:38 am #

      Vincent,

      As a GUIDELINE, I prefer an ITM strike since there is limited time until expiration for additional exit strategy execution. If we can generate an ADDITIONAL 1-2% of time value with protection we have an ideal situation. An exception would be in a strong bull market I would opt for an OTM strike.

      Alan

  5. Larry Browder April 14, 2013 11:39 am #

    Alan: I enjoyed reading about the stock that gaps up, as I am in the same situation with CELG. I think I will follow your recommendation and buy the calls back and sell the stock. Otherwise, i am just playing the time decay game and will never enjoy the big appreciation. I had taken a little different tact and rolled the options up and out until July. The time value has now almost disappeared due to the stock’s continued rise. Does my thinking here sound reasonable? By buying the calls at almost intrinsic value and then selling the stock, I can put those dollars to work to gain much between now and July. Once again-am I making sense? On another subject, I have signed up to attend the Atl. Options Club meeting next Saturday to hear you speak-I’m looking forward to it! I had pondered the possibility of buying you and your wife [Linda?] dinner either Friday or Saturday night [if you were amenable], but my wife Arline told me we were obligated on Friday night and that I had promised to take her out Saturday night, as April 20 is her birthday. I guess in this case, “it’s the thought that counts”. As a consolation “prize”, I would be happy to buy you lunch after you speak on Saturday if you do not have other plans. You can let me know or we can work it out on Saturday. See you Saturday. Larry

    • Alan Ellman April 15, 2013 7:45 am #

      Larry,

      On the issue of closing your position when the premium is all intrinsic value you are spot on. You’ve maxed your trade (congrats!) and now can use that cash to generate a second income stream.

      Glad you can make the Atlanta seminar.

      Opting for Arline’s birthday celebration over dinner with me and Linda is an ideal exit strategy. There would be way too much risk for conservative investors like us had you taken a different approach.

      I’ll contact you directly once I know my full schedule.

      Alan

Leave a Reply

Optionally add an image (JPEG only)