If you had a $1000.00 more today than you did yesterday, is your net worth +$1000.00 or does it depend where that cash came from (this is not one of my trick questions). What if you earned it at your job? Investment income? Found it on the street? Gift from grandma? Got lucky at the casino? The way I see it, a thousand dollars is a thousand dollars no matter the origination of that cash. It can be withdrawn from the bank and off to the mall we go.
The same can be said of the monetary growth of our portfolio when selling covered call options. Why just close our eyes to the option returns (great as they are) and not consider share appreciation generated through savvy execution of exit strategies. There are times that we can increase the value of our stock by taking advantage of the difference in time value from month to month. I am speaking, specifically, on or around expiration Friday when your share value is higher than the strike price. We know that if no action is taken, our shares will be assigned and sold at the strike price. For purposes of realistically evaluating the worth of our portfolio, the shares are worth the strike price (our obligation to sell at that price) times the number of shares. Any share value above the strike price is NOT ours.
If the stock still meets all system criteria (including a check of the earnings report), the next step is to do our calculations (ESOC to the rescue). If we opt to execute a rolling out strategy, we buy back the option and sell the next month same-strike call. Our profit is the difference between the two premiums divided by our cost basis which is (100 x the strike price) per contract. This strategy is relatively simple to understand and a big money-maker for Blue Collar Investors (see pages 122-123 of Cashing in on Covered Calls).
A strategy that will elevate our returns even higher is when we roll out and up. This is a more bullish maneuver than simply rolling out and utilized when market tone and stock technicals are positive. We also execute this exit strategy on or near expiration Friday when the stock value is above the previously sold strike price. In this case, there is a small gain or more frequently a small loss in option premium but this is only one aspect of the “deal”. By removing the restriction of the first strike sold and elevating that ceiling to a higher strike, we are now enhancing the value of our stock to either the current market value or the new strike sold depending on which is lower. This increase in equity value must be calculated into our portfolio worth, just as the $1000 in our bank account that came from good ole granny. Furthermore, if the new strike is higher than the share market value, there may be some upside potential to sweeten the deal.
Let’s clarify these comments with a real-life example taken from the option chain of SNDA as of the market close on July 2, 2009. Although there are two weeks remaining until expiration Friday, we will treat this as an expiration Friday exit strategy. It is the concepts and ability to apply these ideas in various situations that is of utmost importance.
- Previously purchased 100 x SNDA and sold the July $50 calls
- Current market value is $53.15
- Buy-to-close the July $50 calls = $4.60
- Sell-to-open the August $55 calls = $3.80
- Option loss (4.60 – 3.80) = – 0.80
At this point many covered call writers would be heading for the hills! Why lose $80 per contract? Should we be examining the deal or our heads? Let’s evaluate this deal like a true Blue Collar Investor and factor in ALL facets of this strategy:
By removing the $50 ceiling on SNDA, we are allowing it to grow in value to the current market value of $53.15, thereby gaining $3.15 per share or $315 per contract….grandma just handed us all this cash-we must count it! In addition to that, the ceiling is now @ $55 and our stock can grow in value another $1.85 per share without restiction. Let’s calculate these new, improved numbers:
Loss on option premiums (from above) = -0 .80
Share appreciaition – option loss = 315 – .80 = $235/contract
235/5000 = 4.7% return
Upside potential = 185/5000 = 3.4%
POSSIBLE total profit on this deal = 8.1% (4.7% + 3.4%).
Once again, this is a bullish strategy to be used when market conditions and stock technicals warrant a positive expectation of share appreciation.
Many covered call writers buy a stock, sell the option, get down on their knees, clasp their hands and pray for positive results. Blue Collar Investors, on the other hand, manage their positions with educated, non-emotional decisions, factoring in every bit of information even facts that others can’t see. For more examples of this strategy, see pages 102-109 of Exit Strategies for Covered Call Writing.
Last Weeks Economic News:
After several months of predominently positive economic news, expectations of a quick recoevry were lessened by some negative reports. Job losses caused unemployment to approach 10%, a new 26 year low. Construction spending and consumer confidence declined. On a positive note, the construction industry reported an increase in factory orders and sentiment. For the week, the S&P 500 fell 2.5% for a year-to-date return of 0.6%. Viewing the chart of this major index, we see it to be in a period of consolidation as investors hold their collective breath to see which direction it will turn. A spike up on high volume will be an encourasging sign. The chart:
BIG CHANGES COMING IN AUGUST:
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Video now playing on the homepage:
Suze Orman on covered call writing
My best to all,
Alan and The BCI Team
Thanks, Alan. I have faced that exact situation several times in my portfolio, and historically have let some good stocks be called away because I did not know of any good exit strategies such as those you just described.
Alan – looks like the SPX has a head and shoulders pattern ready to break through the 200 SMA.
With 9 trading days remaining until expiration of the July contracts, I will sometimess assess my returns versus the market. The S&P 500 began the contract cycle @ 914 and is down 2.2% to date. Beating the market on a regular basis is one of my goals that I measure my success by.
I noticed that a majority of the stocks on my list will have earning reports in the next period. The amount of stocks available for options is small. How do you handle this matter?
You’re absolutely correct. I noticed the same thing. First and foremost, don’t be tempted to write calls on these stocks as it is too risky.
Since the pool of equities is limited, the returns will be diminished as we can’t be as selective when it comes to calculations. However, I would rather take a smaller return than risk a big loss because of a negative earnings surprise.
One other thing to keep in mind and this is important: Notice that the August contract is 5 weeks long, most are 4 weeks in duration. Stocks on your watchlist that report in the first week of that contract cycle and still meet the system criteria will be eligible for covered call writing once the ER passes. You will still get a fabulous return on these stocks due to the lengthened contract cycle.
With the market down 4% since the beginning of the current contract period, let’s look at the reasonable results various investors have to show:
1- Those who own stock but haven’t sold the option: DOWN 4%
2- Those who sold A-T-M or O-T-M strikes: DOWN 1-2% ( down 4% from the stock value and up 2-3% from the option sales).
3- Those who sold I-T-M strikes: Up 1-2% (down 4% on the stock value, up 2-3% on option profit and up 2-3% from downside protection). TNDM, URS, PWRD and BJRI are examples of stocks holding up well after selling I-T-M strikes.
I did a scan for good fundies ( Zacks 1 and 2’s ) , IBD!00 , no earnings coming up , > 20 ema
CPA was the only one left for July ?
There are a few for Aug
My question is do you wait till after earnings before proceeding because almost all of the Aug candidates have earnings coming up
so no positions can be taken till about 8/1.
Am I on the right track?
You are 100% on the right track. Under no circumstances does it make financial sense to sell a cc option when a company is expected to report during that contract period. See pages 129-138 of “Cashing in on Covered Calls” for a detailed explanation.
During the heart of earnings season the number of stocks available for purchase will be limited. Don’t be tempted to veer from this critical rule! Most of the time many equities will become available after the first week of the contract period. If the stock still meets our system criteria, it’s okay to jump in at that point.
Once you have a QUALITY watchlist of 40-60 stocks, you will be able to manage this problem and still generate a significant return, although a little lower than the other 9 contract periods in the year ( three are in the heart of earnings season).
Keep up the good work.
EXPIRATION FRIDAY EXIT STRATEGIES DON”T HAVE TO BE ON EXPIRATION FRIDAY:
Expiration Friday is one week away and I will be flying to California for a private seminar that day. In our busy lives, events like this is not uncommon . There is no law that says that we can’t unwind our positions prior to expiration Friday, even today for example.
Last month, I sold several contracts of the July $34 calls and July $35 calls for the Qs (QQQQ), an exchange-traded fund, in my mother’s account. As of (pre-market opening) today, the Qs are sitting @ $34.77, a nice number for the contracts I sold. If I were to roll out on both today, I would generate a 2%, 5-week return (August is a long 5-week contract period).
If this is a deal you like, and you’re busy the final week of the contract period, it’s time to generate some cash into your account.
Not about stocks, but I enjoyed this so much I thought I’d share it with you…speakers on:
My next journal article will discuss the risk-reward profile of covered call writing through the eyes of an educated Blue Collar Investor.
I will also be providing you with some new links to help you evaluate exchange-traded funds.