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WHEN TO BUY BACK YOUR OPTION – EXPIRATION FRIDAY DILEMMA plus Industry in the Spotlight

Picture this: It’s on or near Expiration Friday and your stock or ETF (Exchange Traded Fund) is above the strike price. You know that if you do not act to institute an Expiration Friday Exit Strategy your stock will be assigned (sold). So what are the factors that will determine whether or not you buy back the option and therefore keep your shares? Before we even look at the calculations, there are 3 tests your security must pass:

1- Is it fundamentally sound?

2- Is it technically sound?

3- Is there an Earnings Report scheduled for the upcoming contract period?

The first 2 tests are usually passed because the price of the equity has been rising. Make no assumptions…check it out.

ER dates should be noted next to all stocks on your watchlist. Those of you familiar with my system know that avoiding the sale of options prior to an ER is critical to the success of your investments.

Let’s now make the assumption that all 3 tests were passed and we move on to the calculations. Is this financial soldier prepared to enter the investment battlefield and come home with lots of friends? Put another way…how much cash are we going to make? Many option sellers are hesitant to buy back an option because they feel that it is eroding the profit they generated the previous contract period via the original sale of the option. I look at it completely differently. The money we made from the original sale of the option is ours to keep no matter what happens to the stock. That is a deal from the past. If we decide to buy back the option it is only with a concurrent sale of another option in mind. This is a completley separate deal to be evaluated on its own merit having nothing to do with the original option sale. The point here is not to cloud your decision as to whether to buy back an option by factoring in last months option profit.
 
There is nothing like an example to clarify a point. I will use the most common Expiration Friday Exit Strategy that I invoke. It is called Rolling Out or Foward. The definition of Rolling Out is: Closing out of an options contract at a near-term expiration and opening a same strike option contract at a later date. In the example I am about to give, you sell the September $80 call, buy it back, and then sell the October $80 call. here’s how it works:

1- Buy 100 x Company XYZ @ $78

2- Sell 9/80 strike (put the cash in your pocket, keep it, and move on to the next deal).

3- Current price is $83 near Expiration Friday.

4- The current value of your investment is $8000 because you are obligated to sell @ $80.

5- You buy back the 9/80 call for $3.10 ( $3 intrinsic value and .10 for the negligible time value).

6- You sell the 10/80 @ $6 generating a net profit of $2.90 ($6 – $3.10) or $290 for the 100 shares.

7- Your profit is 290/8000 = 3.6% for 1 month or 44% annualized.

8- Since the strike price is $3 in-the-money you have downside protection as well of 3.8% (300/8000).

So here is your dilemma: Are you willing to accept a 1-month 3.6% return WITH a 3.8% downside protection on one of the greatest performing stocks in the stock universe that is both fundamentally and technically sound? As I always say…no rocket science required here, just common sense. Once you understand how this works, you will be making these decisions in seconds and will not need anyone to tell you what to do (including me).

For purposes of being thorough, I should mention that in addition to rolling out, there are 2 other possible scenarios that will make you tremendous profits with Expiration Friday Exit Strategies. They are:

1- Rolling Out and Up – Out-of-the-money.

2- Rolling out and up – In-the-money.

Calculations for all these strategies are done automatically by the ESOC (Ellman System Options Calculator) using the “What Now” tab. I hope most of you utilize this tab as it can be great source of profits in your investment portfolios.

I will be going into great detail regarding these strategies at my next seminar series in October. Many of you have requested I do a webinar since our readers are located throughout the country as well as internationally. I am trying to make such arrangements. Those who want early notification of these seminars, send me an email with your contact information:

alan@thebluecollarinvestor.com

Those of you who previously asked to join this list need not resend your contact information.

Last Week’s Economic News:

The market rallied last week when the Federal Reserve announced that it would keep its target federal funds rate @ 2%. The S&P 500 rose 2.9% on the day of the announcement.

Other positive news included June factory orders, which increased at their fastest pace in 6 months and non-farm productivity which rose at an impressive rate given the current economic climate.

Negative news included consumer debt showing its largest monthly increase in more than 6 months.

For the week, the S&P 500 also rose 2.9% to 1296 resulting in a year-to-date return of -10.6%

Industry in the Spotlight- Trucking:

Shares of equities in the Trucking Industry have been appreciating in value both over the last week as well as the last several months. This demonstrates that institutional investors are taking positions in these stocks. In my view, this is the single most important factor in determining which equities to own. If you check the Group Technical Rating for these equities you see an A+. Interestingly, the Fundamental Rating of most of these securities is rather average. This made it difficult to locate stocks in this industry that met our system criteria. I did find two.

One possible explanation for the great group technical and so-so stock fundamentals could be related to the price of fuel. Generating profits in the transportation business had tremendous hurdles to overcome with oil @ $150 a barrel.
Now that there are indications that these prices are coming down and staying down, the prognosis for higher profits is much better. Perhaps the “big boys” are recognizing that and starting to buy up these equities.

To review what the Group technical of A+ is telling us:

– This industry ranks among the best in overall price performance.
– Many of the stocks within the industry are nearly 52-week highs.
– Moving Averages are uptrending.
– Closing daily prices are at the higher end of the trading range.

The 2 stocks that DO meet our sytem criteria are:

JBHT

FWRD

Two that come close and may be worth keeping an eye on are:

HTLD

ODFL

Once again, for early notification of my October seminar or webinar series, send your contact information to me at:

alan@thebluecollarinvestor.com

Best regards to all,

Alan

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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.

7 Responses to “WHEN TO BUY BACK YOUR OPTION – EXPIRATION FRIDAY DILEMMA plus Industry in the Spotlight”

  1. Eric R August 11, 2008 6:37 pm #

    This makes sense, but what do I do in the following scenario? Lets say I have been steadily buying a position in the QQQQ’s and I now have 300 shares and decide to start selling options. I sell 3 Aug QQQQ’s that are ATM in mid-July. When August expiration rolls around my options are deep ITM and it is not feasible for me to buy them back and sell the next month’s option. In your book “Cashing in on Covered Calls” you say if an option is ITM and it doesn’t pay to buy it back to just let it get called and move on to another equity. However, I would think it would be different with ETF’s since I am trying to build a longer term position. Do I just let my 300 shares get called at expiration and start building another position from scratch or is there another solution? Any help is appreciated. Thanks!

  2. admin August 12, 2008 9:59 am #

    Eric,

    Questions about my Basic Seminar are equivalent to High School. Questions about Advanced Seminars I, II, and III are on the college level. Your question about deep-in-the-money ETFs are akin to getting your Doctorate at Harvard. As you know, I sell options on ETFs (the Qs) for my mother. I have faced your situation a myriad of times over the years.

    The first question I ask myself is : Would I buy this security today at the current price? Some of the factors I consider when making this determination are chart pattern or technical analysis, current market sentiment ( an uptrending market probably yes; downtrending maybe no), and recent price history. If the fund recently had a huge price increase, I would tend to be more conservative and allow assignment. If I came to the conclusion that I WOULD want to own the ETF at the current price I start my calculations.

    A key point I would like to make is this: If you buy back the option, most of that premium is applied to increasing the value of the security. In the example I gave in this article, if the stock is at $83 and you buy back the option for $3.10, the stock you now own is worth $83, not the $80 you were required to sell the stock for prior to the buy-back. Therefore, most of the premium is “returned” to you in the form of share appreciation. It is almost the same as allowing assignment and then repurchasing the shares at the higher price. If this is the path you take, you now own an ETF @83 and can sell the in, at, or out-of-the-money strikes. Many times I will “ladder” the strikes in much the same way that many treasury bond investors ladder the 2,5, and 10-year notes.In the case of the stock from my article if the current market value was $85, I may consider selling the $80, 85, and 90 (1 of each).

    If you decide that the price run-up was too quick and overdone, allow assignment and start dollar cost averaging into the ETF. I do this either over 10 or 22 business days.

    10 days: If you have $15,000 in cash, buy $1500 worth of the ETF each day. After 10 days, sell the option on that same months security.

    22-days: Spread the purchases over the entire contract period, skip selling options that month, and get back in the action the following period.

    To get a little trickier, on down days purchase a little more and on up days a little less.

    If you roll out with a deep-in-the-money strike, your return will not be impressive but it may be worthwhile especially with all the downside protection you have. If you roll out and up, you must factor in the increase in your share value in your calculations. This is all done for you by using the “what now” tab of the calculator.

    Finally, no options can be bought back without having extra cash in your account.In the example I gave in this article, if you had 3 contracts to buy back @ $3.10 you would need $930 cash plus commisssion money to allow for such an exit strategy.

    I know from your previous emails that you are currently paper trading. I commend you for this as this is a prime example of a situation you can only master by experiencing it.

    Keep up the great work.

    Alan

  3. admin August 12, 2008 10:22 am #

    I AM OVERWHELMED!

    I can’t belive how many of you have asked to be put on my “early notifcation” list for my upcoming October webinar series.

    As a show of gratitude, I will be giving all who register for the webinar (FROM THIS LIST) a discounted rate and a SURPRISE FREE GIFT!

    Those on this list will be sent all information prior to it being posted on this website. To get on the list (and be eligible for the discounted fee and free gift) simply send your contact info to:

    alan@thebluecollarinvestor.com

  4. Eric R August 12, 2008 11:23 am #

    Thanks Alan! This helps clear things up in my mind how this would work. I figured you may have run into this before with trading the Q’s in your mom’s account. One more question for you if you don’t mind… I know you mentioned in your book that once I have 300 shares of the ETF that I am accumulating I can start selling options. I’m wondering why you recommend the number of shares be 300? Would I run into a problem if I started selling options when I have 100 or 200 shares? Again, thank you for sharing your experience on what can be a complicated aspect of investing.

  5. admin August 12, 2008 12:11 pm #

    Eric,

    300 is not etched in stone. I like it as a starting point because it gives you the flexibility to do the “Laddering” I described in my previous response. You may want to paper trade with a few accounts: 1 contract, 2 contracts, and 3 contracts etc. Then see where your comfort level is. Mine borders on the ridiculously conservative but thanks to covered calls, I still make a great return.

    By the way, laddering is a term ususally reserved for fixed income investments, but I use it for option strike prices because it makes sense to me to do so. Therefore, if you use it in reference to strike prices, do so only on this board!

    Here is the true definition of laddering:

    A strategy for managing fixed-income investments by which the investor builds a ladder by dividing his or her investment dollars evenly among bonds or CDs that mature at regular intervals simultaneously

    Alan

  6. Eric R August 13, 2008 7:31 am #

    Hi Alan – I think all this information is just creating more questions for me as I try to clear up how it would work from month to month. Anyway, I was looking at the calculator and I found where you were saying it figures the “bought up” value of the option. It is starting to make sense how the intrinsic portion of the option buy back is basically the same as if I had allowed assignment and bought back the shares. How does this work when I get into the second month using the calculator? In your example you mention I would pay 3.10 to buy back the option at expiration because the stock is trading at 83. Does this mean when I get into the next month and I’m running my “What Now” scenarios that I use 83 as my “stock share price you paid” value in cell F8? I would think so but thought I would check. Thanks again for you all your assistance!

  7. admin August 13, 2008 10:18 am #

    Eric,

    If you back back the option and resell the 80 call, your cost basis is 80(00). The $3 intrinsic value is credited in the downside protection you get. If you sell the 85 call, the $3 is credited to buying up the stock value and your cost basis is 83. To better understand this 2nd scenario, pretend you allowed share assignment and then repurchased the shares for the current market value of $83. That would be your cost basis.

    Keep in mind that these are common sense accounting tricks that I have developed over the years and assist in determining the best way to make the most money. I would NOT give these calculations to your accountant for tax purposes.

    Alan

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