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Rolling Down And Stock Splits: A Real Life Example

Covered call writing positions can be altered by exit strategies or contract adjustments. Contract adjustments are alterations that are typically made to option contracts when the underlying stock undergoes a stock split, pays a special cash and/or stock dividend or distribution, or is involved in a merger, acquisition or corporate reorganization. Sometimes they are impacted by both as we take advantage of every possible opportunity to enhance our returns. In this article, I will highlight a real-life trade executed by one of our members, Mike, a few months back. In this series of covered call trades, Mike astutely used the rolling down exit strategy mid-contract and then took advantage of a stock split to continue generating income. The stock Mike used as the underlying security was TRN, a stellar-performer on our “Premium Watch List” and also located in the IBD 50 at that time. The series of trades

  • 5/30/14: Buy 100 x TRN @ $87.43
  • 5/30/14: Sell 1 x $90 call @ $1.20
  • 6/6/14: Share price declines dropping option value to $0.20
  • 6/6/14: BTC (by-to-close) the $90 call @ $0.20
  • 6/9/14: STO (sell-to-open) the$85 call @ $1.00 (may have generated a slightly higher return if implemented on 6/6/14)
  •  6/20/14: Stock splits 2-for-1 doubling the number of shares owned by Mike to 200 and cutting the strike price in half to $42.50
  • 6/20?14: Cost basis cut in half to $43.72
  • 6/20/14: Option expires worthless as TRN closes @ $42.23
  • 6/23/14: STO 2 x July $45 calls @ $0.55
  • 7/11/14: Captures $20 cash dividend for the 2 contracts
  • 7/14/14: At the time I am writing this article, TRN is trading @ $44.95, well above Mike’s cost basis of $43.72 (1/2 of $87.43)

 

Initial calculations

  • Initial return = $120/$8743 = 1.4%
  • Initial upside potential = $257/$8743 = 2.9%
  • Possible 1-month return as trade was set up = 4.3%

 

2-month calculations as of 7/14/14

  • Option credits: $120 + $100 + $110 = $330
  • Option debit = $20
  • Dividend credit = $20
  • Share appreciation: $44.95 – $43.72 = $123/contract = $246
  • 2-month profit as of 7/14/14 = $330 + $246 + $20 – $20 = $576
  • 2-month % return = $576/$8743= 6.6% = 39.5% annualized

 

Descriptive chart showing these trades

 

covered call writing exit strategies and contract adjustments

TRN: rolling down with a stock split

1- Stock purchased @ $87.43 and $90 call sold
2- $90 call bought back
3- $85 call sold (rolled down)
4- Stock splits 2-for-1 and option expires worthless…shares kept
5- Sell 2 contracts of the August $45 calls
6- Dividend distributed
7- Stock trading near $45.95

Summary

To achieve the highest possible level of covered call writing returns we must take advantage of every opportunity that arises during the course of the contract cycle. In this article, I highlighted the execution of the rolling down exit strategy and leveraging contract adjustments to maximize our returns. Understanding that stock splits on uptrending securities is a bullish event that will frequently lead us to favoring out-of-the-money strikes.

Packages that run the Ellman Calculators

With the myriad of devices used these days to download and run software, we are always looking for ways to respond to questions regarding the use of the Ellman Calculators. Here is a file researched and produced by Barry Bergman, the BCI Director of Research, that is now available in the “resources/downloads” section of the premium site and will be available in the “free resources” section of the general site as well:

Packages to run the Ellman Calculators

Packages to run the Ellman Calculators

 

Market tone:

The market seems to have calmed relative to the numerous geo-political events that had it on edge. This week’s reports:

  • Business inventories (a report of the dollar value of product inventories held by manufacturers, wholesalers, and retailers. Included in the report is the inventories/sales ratio, a gauge of the number of months it would take to deplete existing inventories at the current rate of sales, which is an important indicator of the near-term direction of production activity) increased by 0.4% in July, in line with analyst projections
  • Retail sales in July were unchanged from June stats, below analyst expectations
  • Retail sales were up 3.7% year-over-year
  • The Producer Price Index or 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) was up 0.1% in July, down from 0.4% in June mainly due to a 0.6% decline in energy prices, the largest since November
  • Industrial production (a measure of the changes in quantity of physical materials and items produced in the manufacturing, mining, and utilities industries) rose by 0.4% in July, better than expected

For the week, the S&P 500 rose by 1.2%, for a year-to-date return of 7.1%, including dividends.

Summary:

IBD: Confirmed uptrend

GMI: 4/6- Sell signal since market close on August 4th…nearing a buy signal

BCI: Moderately bullish on the overall economy and moving to a more bullish approach by selling an equal number of in-the-money and out-of-the-money strikes

My best to all,

Alan (alan@thebluecollarinvestor.com)

www.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.

35 Responses to “Rolling Down And Stock Splits: A Real Life Example”

  1. Roger August 16, 2014 7:22 am #

    Hi Alan,

    Am I correct in assuming that when I STO or BTC an option trade, it is the Market Maker with whom I am transacting?

    Roger

    • Alan Ellman August 16, 2014 7:23 am #

      Roger,

      You are correct or in many cases their computers as technology has replaced the human factor. I recently visited the floor of the NYSE and noticed a market-maker who was more engaged in his “big salad” than he was in his computer that was matching buy and sell orders. You are NOT dealing with other retail investors evaluating your bid-ask prices.

      Alan

  2. Adrian August 16, 2014 10:04 pm #

    Alan, I have another calculation that I did for June and am wondering if the return is the correct one still.
    On the stock ‘AFSI’ I have a buy at $43.48, and STO the $42.50C@ $2.33.
    On Expiry day I wanted to sell stock and with price just above the strike price I BTC@0.15c, and sell stock at $42.55.

    – I am wanting to know if the lower denominator in the total return is $43.48(my buy price), or the strike of $42.50 and how to calculate for the total return? (by my own calculations I have $2.18 of option profits, 0.93c of share loss, for a $1.25/$43.48 = 2.87% return?, – I could be wrong here but is this how you get the return?) Thank you.

    • Alan Ellman August 18, 2014 6:42 am #

      Adrian,

      AFTER the trade has been completed and both the short option and long stock positions are closed we calculate as follows:

      Stock loss: $43.48 – $42.55 = $0.93

      Option credit: $2.33 – $0.15 = $2.18

      Net credit = $1.25

      Cost basis (after trade calculation only) = $43.48 – $2.33 = $41.15

      Final calculation: $1.25/$41.15 = 3.04%

      BTW: If you didn’t buy back the option and the price closed above $42.50, even by one penny, your shares would have been sold @ $42.50 and your profit would have been $1.35 per share for a 3.28% return.

      Nice going!

      Alan

      • Andrew August 22, 2014 5:59 am #

        Why would you want to buy the option back if you can get a higher return (3.28% vs 3.04%) by not buying it back?

        • Alan Ellman August 22, 2014 7:23 am #

          Andrew,

          A valid reason why Adrian may have bought back the option is that he executed the trade when the price was only $0.05 above the strike and was concerned that ther price may close below the strike. He decided to sacrifice $10 per contract to get the reults he was guaranteed by taking this action. If the price did close $0.01 or more below the strike, he could sell the stock on Monday but @ what price? A valid justification could be made for both closing and “allowing assignment”

          Alan

          • Andrew August 22, 2014 11:50 pm
            #

            Ok yeah that’s a good point Alan. So he decided to buy the option back to be safe & sell the stock to take his profit & get out of it right? Another option for him would be he could have bought the option then rolled out to the next month at a lower strike price too right? (if the stock still looked ok) What would you do in this situation Alan? I guess it depends on how much of an option premium you could get too Thanks for the reply. take care,Andrew

          • Alan Ellman August 23, 2014 3:10 am
            #

            Andrew,

            The decision to roll the option depends on a few factors:

            1- Does the stock still meet our system criteria? Probably yes in this case.

            2- Is there an upcoming earnings report in the next month? If yes, do not roll

            3- Does the resulting options credit meet our 1-month goal?

            I never roll out and down. In this case, if rolling, I would roll out (to the same $42.50 strike) or roll out and up depending on the calculations. Use the “what now” tab of the Ellman Calculator for these decisions.

            Alan

          • Andrew August 28, 2014 12:58 am
            #

            Ok Alan, good points. What is the reason you don’t roll out & down? I was thinking by having a lower strike the next month in this case would give you more downside protection than having the strike so close to the share price. Maybe the premium wouldn’t be worth it to go to a lower strike. Just curious. Thanks.

        • Alan Ellman August 28, 2014 6:54 am #

          Andrew,

          When rolling an option we are already rolling to an ITM strike unless we roll out-and-up. The reason is that we roll when the strike is lower than current market value. If we decide to roll out-and-down that implies a particular concern for the underlying and since our 1-month obligation is over, why not move to a stronger underlying? In this scenario, we can “allow assignment” and use the cash the following week for a candidate that we have more confidence in.

          For those with very low risk-tolerance in a bear market environment and no stronger candidates (unlikley), a case can be made for rolling out and down. I will either roll out, roll out and up or use a different underlying.

          Alan

          • Andrew September 3, 2014 10:17 pm
            #

            All right Alan. Yeah, It would make more sense to move to another stronger stock rather than roll out & down. Hey, I have a quick ? on Adrian’s trade where he unwinded & exited his position. You said he “closed & allowed assignment” on this option. But isn’t “allowing assignment” in this example mean you exercise the option & buy the stock at the specified strike price ($42.50), because he bought the option back he has the right to buy it at this price). Ok he bought the option back & sold the stock for a net credit but I don’t understand what happens to the option after he bought it back. Did it expire worthless or did he exercise it & buy the stock at $42.50? I don’t think he bought the 100 shares at 42.50 because he already owned the stock & it wouldn’t make any sense to buy it barely below the market price right? (42.50 vs 42.55) so he just let the option “expire worthless” & didn’t “allow assignment” & sold his shares he already had, right? Or am I incorrect on this? Thanks again, Andrew

          • Alan Ellman September 4, 2014 5:29 pm
            #

            Andrew,

            If Adrian didn’t first sell the option, you would be correct that he would have the right to buy the shares at the strike price. However, since he did first sell the option and bought back the same exact option, the 2 positions. in effect, cancel each other and Adrian has no option rights. When he bought back the option he simply owned the shares long and then decided to sell them @ market price.

            Alan

          • Andrew September 4, 2014 8:45 pm
            #

            Oh ok, so after he sells it then buys it back, its like cancelling your sell. Thanks for your reply. But is that called “allowing assignment” when you do that? I guess you would be doing that, its just not taking ownership of the shares because you already owned them

        • Alan Ellman September 6, 2014 5:58 pm #

          Andrew,

          “Allowing assignment” means that you take no action when the strike price is in-the-money @ expiration. You know that by taking no action your shares will be sold and therefore you have decided to “allow this assignment”

          Alan

  3. Barry B August 17, 2014 1:01 am #

    Premium Members,

    The Weekly Report for 08-15-14 has been uploaded to the Premium Member website and is available for download.

    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 BCI YouTube Channel link is:

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

    Best,

    Barry and The BCI Team

  4. Tiong August 17, 2014 10:48 am #

    Hi Alan

    I have been delighted with the results after coming on board the BCI community. Thanks alot for your timely blogs.

    In the initial selection of the option strikes for the covered call I noticed that some options has higher time values in the ITM strikes while other options has higher time values in the OTM strikes. Would really appreciate your layman explanation how this comes about. Would it be a safe strategy to just choose the strikes providing the highest time value (ROO)?

    Thanks
    Tiong

    • Alan Ellman August 18, 2014 6:53 am #

      Tiong,

      I really appreciate your question because it is a common misconception that the best strike to select is the one that generates the highest returns…definitely not the case.

      The best way to handle calculations and strike selection is to set a range of goals for the time frame your are investing as it relates to initial returns. Mine are 2-4% per month. Some members may set their goals higher or lower depending on personal risk tolerance.

      Once a goal is set, select the strike that is based on chart technicals and overall market assessment. For example, if the chart technicals are bullish and confirming (bold stocks on our premium stock reports) and our overall market assessment is bullish I lean to out-of-the-money strikes that also meet my initial goals.

      Now let’s get to the time value issue. The closer the current market value of the stock is to the strike price, the higher the time value. That’s why at-the-money strikes have the greatest time value. So if the ITM strike is closer to the current stock price than the OTM strike, it will usually have more time value and vice-versa.

      Have a look at the options chain for CAVM below, trading @ $51.72. Notice that the $50 ITM strike has more time value than the OTM $55 strike because the curent market value is closer to $50.

      CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.

      Alan

  5. Marc August 18, 2014 7:19 am #

    Hi Alan !

    Marc again here. Hope you stay well.

    I have a question.

    What is wrong, in holding long puts, let us say expiring in 6 months, in combination of covered calls we write month after months ?

    Let me know.

    Thanks in advance.

    Cordially,
    Marc

    • Alan Ellman August 18, 2014 7:41 am #

      Marc,

      There is nothing wrong with purchasing protective puts. As with all strategies there are pros and cons that must be evaluated by the investor to see which are most appropriate for their portfoluios.

      The clear advantage of buying puts to protect our cc positions it that they will shelter us from a catastrophic loss in share value. The main disadvantage is that they will decrease our initial returns depending on the amount of protection we are opting for. By buying long-term puts we have the advantage of lower monthly cost but we are also commiting to the underlying for a longer time frame unless we close our postions and the reasons we selected the underlying security today may not be in place in 3 months.

      Alan

  6. Larry August 18, 2014 7:21 am #

    Hi Alan,

    Did I recently read that you will be publishing a book devoted to selling cash secured outs? If so, when do you anticipate its availability ? Do you have any “Ask Alan” clips on the topic ?

    Larry

    • Alan Ellman August 18, 2014 10:23 am #

      Larry,

      Yes, the book is currently being edited and the graphics for the covers are being designed. I’m hoping to have the book available to our members within 2 months and then published on Amazon.com shortly thereafter. I’ll send out email notifications to our premium and general members when I get the initial batch of “author copies”

      Here is a link to an article I published that touches upon this topic:

      http://www.thebluecollarinvestor.com/using-cash-secured-puts-to-enter-covered-call-positions/

      Expect much more on this subject after the book is published.

      Alan

  7. Mike August 18, 2014 11:47 am #

    Alan,

    I have just started paper trading and I am having a problem.

    Last night when I received my watch list I made all of the calculations to determine which stocks and options I wanted to trade.

    This morning when I went to place my orders I found that all of the numbers had changed. The trades that I wanted were not there. If I recalculate my list I am sure that by the time I finish the recalculation and place the orders the numbers will change again.

    I feel like I am trying to hit a moving target. How do you handle this situation?

    Thank you,

    Mike

    • Barry B August 18, 2014 12:39 pm #

      Mike,

      The data points that you used last night (I’m assuming Sunday night) are based on the closing prices on Friday night. The options pricing is inaccurate over the weekend with the bid/ask prices artificially high. If you are placing new trades, you need to wait for the opening on Monday morning. i would recommend that you wait for an hour (+/-) to allow for the market makers to adjust the option prices after the weekend. As a matter of fact, unless you are executing some specialized strategy that takes into consideration opening prices and gaps, I suggest that you wait an hour under any circumstances.

      Best,

      Barry

  8. Adrian August 19, 2014 2:34 am #

    Alan, thanks for giving me correct calculations as I think I will now need to change all my papertrade returns for the last 11 months, as the ones I have probably aren’t right.
    I had always thought that when you sell an ITM option and price is above the strike price after expiry that the return is based on the strike($42.50)price, yet if it is below the strike price after expiry then the return is then based on buy($43.48) price. Is the return you worked out a final month return instead of tax calculation return?

    – My main question here, is if I am to check the ER’s dates of stocks I use every week on earningswhisper.com, as a stock I used (‘TTM’)reported 2 & 1/2 weeks earlier in my trading month?, – it’s the same with dividends the stock ‘SWKS’ had a dividend when this wasn’t expected until much later – check yahoo.com every week too?
    It is lucky these were papertrades, and I won’t be thinking of live trading until I have a much better understanding of all this and all questions answered too – I reckon about another 20 to ask.
    I’m really grateful for your help so far. Thanks

    • Alan Ellman August 20, 2014 6:31 am #

      Adrian,

      The calculations I gave above are for both final calculations and tax calculations as well, as calculated here in the US. In these cases, the option’s premium is factored into your cost basis. When a trade is first entered, I only deduct intrinsic value if an ITM strike was sold until we know the final outcome. The Ellman Calculator will do all the math for you and the Schedule D from the Elite Calculator will assist with final calculations and long and short-term capital gains (losses). As a premium member you have access to the Elite Calculator in the “resources/downloads” section of the premium site.

      As far as earnings reports are concerned, earningswhispers.com has been our most reliable source but companies can change the dates slightly at any time. Notice that our reports will place in “red/bold” all ER dates that have been confirmed by the corporation.

      Regarding dividends, be sure to check the EX-DIVIDEND date, not the record date or the date of distribution. This is the date that will assure capture of the dividend and also the date share value will decrease by the dividend amount. It is the ex-date that appears in our premium reports and these dates are the most accurate available to us.

      Alan

  9. Alan Ellman August 19, 2014 4:37 am #

    Running list stocks in the news: AKRX:

    Akorn Inc. had another earnings report “beat” on August 5th by 27% on the earnings side and by 5.6% on the revenue side. This trend has caused estimates to increase as well resulting in the stock to earning its way onto our Premium Watch List now for 12 weeks.

    Our “running list” shows that AKRX is in the Medical industry currently ranked in the top 20% of industries (A rating), has beta of 1.16, has adequate open interest for near-the-money strikes and its next earnings report is projected to be on November 4th.

    The chart below shows the recent positive earnings surprises and the increasing earnings estimates. CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.

    Alan

  10. Justin August 19, 2014 2:34 pm #

    Alan,

    Here’s a hypothetical example and does not include any prices, strikes, or premium amounts.

    When we sell an OTM put to open, and the underlying’s price falls to the put’s strike, assignment occurs. We can then sell a covered call against our shares. My concern is this: do we create a wash-sale scenario if we choose to sell an ITM covered call with a strike LOWER than the strike of the originally opened OTM put? Would this create a wash sale scenario only if the lower call strike is exercised?

    I can create a hypothetical scenario with prices if that helps, but you always seem to read between the lines with our questions. Thank you for having that ability as well as teaching how to create passive income selling CCs!!

    As always, thank you,
    Justin

    • Alan Ellman August 19, 2014 2:46 pm #

      Justin,

      First, thank you for your generous comments.

      Whenever I get a tax question, I always premise my response by stating the obvious: I am not a tax expert and you should always consult with your tax advisor for final validation. Here is my layman’s perspective:

      These are NOT subject to wash rule trades. When the put is exercised you will purchase the shares at a cost basis of strike price – option premium. There may be an unrealized gain or loss but nothing subject to the wash rule.

      If you sell an ITM call option you are not buying back a security that has taken a loss so that too is NOT subject to the wash rule. If the call option is exercised, we have a capital gain or loss depending on the initial cost basis and call strike but again even if there was a loss we haven’t at that point in time repurchased those shares within a 30-d time frame.

      The wash rule applies to “sustantially similar securities”. When rolling down, we are selling different securites because of the lower strike prices. If the stock is called at a loss, the wash rule will not apply unless we re-purchase that security or an option that gives us the right to purchase within a 30-day window.

      If there are any accountants or tax advisors out there with another perspective, I’d love to hear from you.

      Alan

  11. Gary August 19, 2014 6:29 pm #

    Alan,

    Do any of your videos explain why the portfolio summary from the broker shows the call as a debit?

    Gary

  12. Zhong August 19, 2014 7:13 pm #

    Hi Alan,

    In you book book “Alan Ellman’s Complete Encyclopedia for
    Covered Call Writing”, chapter 15, you listed the “Disadvantages of using LEAPS”, the first one is: You do NOT capture stock dividends” I am confused about this statement, this conflicts with the strategy described in section (Chapter 20) “Using covered calls to increase dividend yield” which
    sell a long term LEAPS deep ITM call options.

    Do the two places mean different strategies?

    Thank you.
    Zhong

    • Alan Ellman August 19, 2014 7:18 pm #

      Zhong,

      Yes, these are 2 completely different strategies. In Chapter 15, I discuss a strategy where we BUY LEAPS as a stock replacement strategy. Once we own the long-term option, we then write short-term calls against the long position. If we own LEAPS instead of stocks we will not capture the dividend.

      In Chapter 20, pages 402 – 405 I discuss a strategy where we SELL LEAPS to decrease our cost basis and thereby increase dividend yield.

      Alan

  13. Alan Ellman August 20, 2014 6:42 pm #

    Premium members:

    This week’s 8-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site. The report also lists Top-performing ETFs with Weekly options as well as the implied volatility of all eligible candidates.

    ***You will notice that the implied volatility of the S&P 500 as well as almost every ETF in our report is lower than it was last week reflecting a calming of market sentiment at least over the next 30 days.

    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

  14. Alan Ellman August 21, 2014 10:46 am #

    BCI WEBSITE NOW IN 80 LANGUAGES:

    Because we have members from over 90 countries my fabulous team just added a new feature located under the google search tool at the top of our web pages where the site can be viewed in over 80 languages. However, expect responses from me to only be in English!

    Alan

  15. Alan Ellman August 21, 2014 3:53 pm #

    Running list stocks in the news: TTM:

    Tata Motors Limited is India’s largest automobile company, the world’s 5th largest truck manufacturer and 4th largest bus manufacturer. On August 12th, Tata launched the Tata Zest, its 1st new model in 4 hyears and geared to India’s rising middle class. TTM plans to introduce 2 new models each year.

    On August 11th TTM announced a stellar 1st quarter ER with sales up 38% year-to-year and as a result estimates have been on the rise as well.

    Our Premium “Running List” shows an industry rank of “A”, a beta of 1.76, a % dividend yield of 0.30 with weekly options available. For those using this security for cc writing please make sure the strike selected has adequate open interest and/or a bid/ask spread of $0.30 or less as some the the strikes are lightly traded.

    Alan

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