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20%/10% Guidelines: Calculating Cost Basis and Option Premium After Rolling Out And Up

Exit strategies or position management for covered call writing and selling cash-secured puts is one of the three required skills we must master to achieve the highest levels of success. One of the most important strategies we employ is the 20%10% guidelines which guide as when to buy back a covered call option:

  • When option value falls to 20% or less of original sale price in the first half of the option contract
  • When option value falls to 10% or less of original option sale in the third week of a four-week contract
  • When option value falls to 10% or less of original option sale in the fourth week of a five-week contract

For example, if we sold an option for $2.00, we automatically buy it back when option price falls to $0.40 or less in the first half of a contract of to $0.20 or less in weeks three or four depending on contract length. This can even be set up as a limit order immediately after entering the trade.

Rolling out-and-up

Another exit strategy available to us is rolling-out-and-up when share price has accelerated above the strike price as expiration is nearing. In this scenario, we buy back the option and sell the next month higher strike price. The question now arises as to how to calculate our new cost basis and option premium as it applies to the 20%/10% guidelines in the upcoming contract month. To assist in understanding these concepts, let’s take a real-life example from the BCI Premium Watch List as of June-July, 2016:

 

Rolling out-and-up with Five Below Inc. (FIVE)

  • Original option sale was for the June, 2016 $45.00 strike
  • Share price as expiration approaches is $45.42
  • Cost to close the $45.00 strike is $0.60
  • Premium generated from the sale of the July, 2016 $47.00 call is $1.00

 

Calculating rolling-out-and-up returns using the “What Now” tab of the Ellman Calculator

calculating covered call writing returns

Rolling Out-And-Up With FIVE

 

The Ellman Calculator shows us that our initial return is 1.82% for one month. If share price moves up to the $47.00 strike, there is a potential one-month return of 5.33%. Once this position is established, what are our 20%/10% guidelines?

 

Calculating our new cost basis and option premium

Of the $0.60 spent to close the initial short call, $0.42 was intrinsic value which “bought up” the share value from $45.00 to $45.42. This leaves $0.18 of time value as our true cost-to-close. Our new cost basis for purposes of evaluating our current position is $45.42 and our net option premium for the upcoming month is $1.00 – $0.18 = $0.82. This can also be derived from the cell highlighted in brown in the Ellman Calculator spreadsheet.

 

Establishing our 20%/10% guidelines

This would make our 20% guideline $0.164 and $0.082, 16 cents and 8 cents. These are guidelines so I would estimate in the $0.20 range in the first half of the contract and in the $0.10 range in weeks three or four depending on contract length.

 

To simplify

Deduct the time value cost-to-close the near-month option from the next month premium to establish the option premium from which our 20%/10% guidelines are calculated. Or simply check the calculator cell “net return w/o upside potential”

 

Discussion

When establishing option premium amount for purposes of setting our 20%/10% guidelines after rolling out-and-up, we must deduct the time value cost-to-close the near-month short call from the next month premium.  This stat can be gleaned from the “What Now” tab of the Ellman Calculator.

***On an unrelated note, have a look at what a disappointing earnings report did to this stock on Thursday 1/26/2017.

***Many thanks to Paul S. for inspiring this article.

 

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1:30 PM ET (Monday)

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2- March 21st and 22nd, 2017

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3- April 12, 2017

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Market tone   

Global stocks moved up, led by US shares, with the three most-important US indices — the Dow Jones Industrial Average, S&P 500 Index and Nasdaq Composite Index — all setting records during the week. West Texas Intermediate crude increased to $53.10 per barrel from $52.40. Volatility, as measured by the Chicago Board Options Exchange Volatility Index (VIX), fell to 10.58 from 12.4 last week. This week’s reports and international news of importance:

  • US economy slowed in fourth quarter to an annualized pace of 1.9% in Q4 from the 3.5% reading in Q3.
  • One bright spot in Friday’s US data releases was a third straight month of improved capital expenditures
  • The Trump administration took a series of executive actions in its first week in office including approving the long-stalled Keystone XL and Dakota Access pipelines
  • President Trump met with the CEOs of several manufacturing companies, including the Big Three automakers, and encouraged them to build new plants in the United States. Trump also met with union leaders
  • The administration also announced it will nominate a replacement for Supreme Court justice Antonin Scalia on February 2nd
  • Foreign trade, much discussed by candidate Trump, remains a major focus, with the new president this week threatening a 20% tax on Mexican imports
  • The Dow Jones Industrial Average closed above 20,000 on Wednesday for the first time in its 120-year history
  • Economically, Brexit has not been the disaster that pundits predicted. GDP grew by 0.6% in Q4, and by 2% for 2016 as a whole. On Friday, the prime minister became the first foreign leader to meet with President Trump, discussing a post-Brexit trade pact with the US
  • A weakening yen and strong US auto sales in 2016 help boost Japan’s trade balance into surplus for the first time in six years
  • While the Canadian government has not taken any final decisions on how it will approach the renegotiation of the North American Free Trade Agreement. Mexico is in a much worse bargaining position than Canada, so that it would not make sense to create a joint front against the US.

THE WEEK AHEAD

MONDAY, JAN. 30th

  • 10 am Pending home sales Dec.

TUESDAY, JAN. 31st

  • 10 am Consumer confidence index Jan.

WEDNESDAY, FEB. 1st

  • 8:15 am ADP employment Jan.
  • 9:45 am Markit manufacturing PMI Jan.
  • 10 am ISM manufacturing Jan.
  • 2 pm FOMC announcement

THURSDAY, FEB. 2nd

  • 8:30 am Weekly jobless claims

FRIDAY, FEB. 3rd

  • 8:30 am Nonfarm payrolls Jan.
  • 8:30 am Unemployment rate Jan.

For the week, the S&P 500 was up by 1.03% for a year-to-date return of 2.50%. 

Summary 

IBD: Market in confirmed uptrend

GMI: 6/6- Buy signal since market close of November 10, 2016

BCI: I am currently fully invested and have an equal number of in-the-money and out-of-the-money strikes. From a purely economic perspective, I am concerned about the apparent nationalistic policies of the new administration in what is an unavoidable global economy. Despite all the bullish signals, I have a neutral to slightly bearish overall market assessment.

WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US

The 6-month charts point to a neutral to slightly bullish outlook. In the past six months, the S&P 500 was up 6% while the VIX (10.58) declined by 16%.

_____________________________________________________

Wishing you the best in investing,

Alan ([email protected]) and the BCI team

 

 

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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.

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24 Responses to “20%/10% Guidelines: Calculating Cost Basis and Option Premium After Rolling Out And Up”

  1. Nehemiah January 28, 2017 7:54 am #

    I have RF, which I plan holding for the long term.

    Cost basis $14:34

    Sold $14 RF Feb call
    Received $78 per contract of which gives me $34 downside protection.

    If the call drops were there is little time value for example $40 per contract would it be wise to BTC and seek the next month

    • Alan Ellman January 28, 2017 8:04 am #

      Nehemiah,

      The original option premium you generated of $0.78 per share is yours to keep no matter what the subsequent price of the option may be. If the option value declines to $0.40, it could be due to time value erosion (Theta) which is the normal calendar day deterioration of option value and a benefit to option-sellers. It could also be the result of a decline in volatility of RF or in the price of RF. We consider closing the original option when the 20/10% guidelines are approached and in this case $0.40 represents more than 50% of the original option sale price. This does not appear to be a situation when rolling out to the next month will benefit us .

      Alan

  2. Jim January 28, 2017 8:22 am #

    Alan;

    I enjoyed yesterdays new Blue Hour video!

    Today I also reviewed the first Blue Hour video on overwriting.

    The segment was helpful.

    I was surprised to see no reference to your technical analysis procedure being used when overwriting.

    I’ve been tracking my stocks now held on the BCI CC Candidate Stock Evaluation Worksheet in hopes of finding the window of opportunity to write a CC.

    Am I safe to look at a current option chain and find the .5% profit window instead of all the research I now am doing?

    I’m anxious to do a CC, but foolishness isn’t part of my desired goal!

    Thanks for the help

    Jim

    • Alan Ellman January 28, 2017 8:32 am #

      Jim,

      My responses:

      1- Technical analysis is a major part of our 3-pronged stock screening process as well as an important factor in strike price selection. However, implicit with portfolio overwriting, we already have our stocks selected from our long-term buy-and-hold portfolios and we are targeting only out-of-the-money strikes that generate 1/2% per month (using the approach from the webinar you referenced). Therefore, technical analysis becomes less of a factor with this strategy. I would consider technical analysis when evaluating rolling strategies when applicable.

      2- Yes, achieving 1/2% for the February 16, 2017 expirations is possible depending on the stocks currently in your long-term buy-and-hold portfolio. Re-check option chains when markets are open.

      3- Glad you enjoyed the Poor Man’s Covered Call webinar. It should be available for replay on the premium member site this weekend.

      For details on technical analysis see Chapter 4 in both versions of “The Complete Encyclopedia”.

      Alan

  3. Daniel January 28, 2017 3:21 pm #

    Yesterday I purchased my first covered calls every.

    The stock and calls were in the company called STMicroelctronics symbol STM.
    I purchased 300 shares of stock and sold 3 calls for .05 Feb 17 15.00 call.

    I purchased the stock because it just reported what I thought were good earnings. Also, good news about supply chips for the new Iphone 8. The stock chart, looks great for now. and also the stock and call was cheap and I thought this is going an learning lesson. So far so good, I made about $100 since buying the stock.

    I have one question, on my brokerage account, why is there a minus sign in front of my Market Value. This is because I’m still OUT of the Money and that sign will turned positive when the stock price passes the strike price.

    I have learned a lot from your free video courses on calls and puts. Recently, I purchased 3 of your books for my kindle. The books were on Covered Calls, Selling Puts and Exist Strategies. I’m currently reading your Covered Calls book.

    Thanks again,

    Daniel

    • Alan Ellman January 29, 2017 8:05 am #

      Daniel,

      The negative sign in front of the option we sell is an accounting procedure used by all brokerages. It indicates that we are “short” the option and it is still in an “open” position and may have to be bought back. The cash we generate when we sell the options is in our cash account…check it out. Once the option is exercised, bought back or expires worthless, the minus sign will disappear. The cash we collect from the initial option sale is ours to keep. Here is a link to an article I published on this subject:

      https://www.thebluecollarinvestor.com/executing-a-covered-call-trade-a-step-by-step-look-at-our-broker-statement/

      Alan

  4. Barry B January 28, 2017 11:28 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 01/27/17.

    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 we are in Earnings Season, be sure to read Alan’s article,

    “Constructing Your Covered Call Portfolio During Earnings Season”. You can access it at:

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

    Two other items this week:

    [1] The video of the “Poor Man’s Covered Call” webinar will be uploaded this weekend to the Premium Member site.

    [2] The “Blue Chip Report” for Feb. 2017 has been uploaded. Look for it in the Resources and Downloads section of the Premium Member site.

    Best,

    Barry and The BCI Team

  5. Jay January 30, 2017 12:17 am #

    Hey Roni,

    I got a kick out of your comment last week about “see you on next week’s thread” :). I guess it is the rare week when you and I do not share market observations! I hope other friends here do not mind…because i enjoy our conversations very much.

    Did you fill out your shopping list last week for Feb or early March expiry? If not something tells me you might find some bargains in the morning. Looking at the futures as of this time stamp Sunday CST markets are off a bit

    Apple reports this week along with all the economic events Alan laid out above.

    So if there is a “Trump Ban” dip tomorrow I will view it as a chance to buy Premium List stocks or sell puts on them further under market value. The rest of the week sets up strong in my view unless I under estimate the global Trump reaction versus economic news

    I am not shy with commentary: there needs to be some negative reaction in global markets to the Ostrich like isolationism of Trump, even if symbolic and brief tomorrow, or I have misjudged it again :). – Jay

  6. Roni February 1, 2017 6:28 am #

    Hi Jay, nice to see you.
    It is my pleasure to talk to you every week, and we are always discussing the most recent market events within the scope of the BCI methodology, so I believe we are not annoying other members..

    I am now almost fully invested for the February 17th contracs.
    I tried to get RJF ATM for a 2% ROO yesterday, but did not get a fill. I will try again today.

    The Trump backlash is impossible to evaluate, but I believe it will be a short and insignificant correction.

    The most important Trump measures like the tax reduction for corporations, the the infra structure 1 trillion budget, and the return of the cash retained by American corporations in foreign countries.
    These will certainly affect the market positively.
    Also the Oil&Gas new focus will certainly change that industry.

    Roni

    • Roni February 1, 2017 3:44 pm #

      Just got a fill for RJF buy/write 75.00 Feb. 17 calls at a 2.4% ROO.
      So now I am fully invested.

      Roni

    • Jay February 1, 2017 3:53 pm #

      Hey Roni,

      Well, I got what I hoped for Monday and Tuesday and took advantage of it to buy a couple things. I used the drops in NVDA to sell cash secured puts on it down at the $100 support level. It has since shot back up to $113.5 with another add today on APPL’s coat tails.

      No change in rates so that hurdle is cleared today. You were right, the reaction to last weekend’s Trump news did not last long.

      I saw an interesting chart today. It showed the three popular metrics many people watch for the S&P in January: the Santa Claus Rally, the first 5 trading days and the month end result. Since 1970 all 3 have been positive 18 times – including this year – and EVERY year that happened the market was positive for that year. Not a pattern Trump wants to break 🙂 – Jay

    • Roni February 1, 2017 3:59 pm #

      Ooops,
      sorry my mistake.

      ROO = 1.6% not 2.4%.

      I forgot that this trade was 0.63 ITM.
      But I’m very happy with it, as 1.6% is very good for a 16 days period, and also gives me a little bit protection.

      Roni

      • Jay February 1, 2017 4:17 pm #

        Who would not like .1% per calendar day for a year :)? – jay

        • Roni February 2, 2017 1:29 pm #

          Your NVDA trade is a very good choice.
          My 105.00 Feb 10 calls are getting deeper and deeper ITM each day, but earnings release was rescheduled for Feb 09, or maybe I made a mistake when I sold the calls.

          Anyway, I’m not worried. Will wait till the last moment to decide.

          • Jay February 2, 2017 2:07 pm
            #

            Thanks, Roni,

            I missed the “NVDA Train” you and others are riding not owning any. I figured I would just sell the 100 cash secured puts as hopefully an income trade letting them bleed off as NVDA recovered, buy back before earnings then look at ownership. Had it kept falling I was perfectly fine with owning it at $100. – Jay

  7. Seth February 1, 2017 10:25 am #

    Alan,

    I want to thank you for your rule not to sell covered calls before an earnings report. I did not sell calls for Apple and today it reported a positive report and is up 5%. Now my question is should I sell the call now or wait for the march contracts?

    Thanks for all you do.

    Seth

    • Alan Ellman February 1, 2017 12:49 pm #

      Seth,

      In addition to the $7 per share price appreciation we can generate an additional 1/2 to 1% by selling out-of-the-money strikes that expire in 2 1/2 weeks. As I type, the $129 strike generates 1.2%, the $130 strike 0.9% and the $131 strike 0.6%. I usually require an additional 1% mid-contract so I would consider the $130 strike which would also allow for an additional 1% of upside appreciation.

      The other choice is to wait for the March contracts after February contracts expire.

      See screenshot below.

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

      Alan

  8. Alan Ellman February 1, 2017 5:33 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.

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

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

    NOT A PREMIUM MEMBER? Check out this link:

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

    Alan and the BCI team

  9. Tim February 1, 2017 6:30 pm #

    Hi Allen,

    I am just starting out with this program and I am excited about it.

    I saw your seminar in Las Vegas 2015. It was very well presented.

    A couple of questions:

    I can see on the option chains that there are weekly segments, week one, two, etc. What does that mean when writing covered calls? What are the mechanics of buying back or modifying your call in relation to exit strategies? How do you accomplish those actions on my brokerage site?

    Are there your videos that explain further about the weekly segments and exit strategy mechanics?

    Thanks, Tim

  10. Alan Ellman February 1, 2017 6:35 pm #

    Tim,

    Not all stocks and ETFs have Weeklys but the number has been increasing to meet the demand for options as they get more and more popular. My personal preference is to stay with Monthlys but we have many members who use Weeklys successfully and I believe that we can succeed with both products.

    Monthlys expire on the third Friday of the month so all other expirations are usually Weeklys (rare exceptions are Quarterlys).

    Here are 3 links to articles I published related to this topic:

    https://www.thebluecollarinvestor.com/weekly-options-standard-and-expanded-expirations/

    https://www.thebluecollarinvestor.com/expanded-weekly-options-when-should-we-enter-a-trade/

    https://www.thebluecollarinvestor.com/rolling-weekly-options-covered-call-writing/

    Alan

  11. Roland February 2, 2017 11:50 am #

    Alan,

    The blue hour on poorman’s covered call was a great education. i checked in with scottrade and found out that in my ira you can’t do a two leg option. they will not let me sell calls against a leap. i was told that i would have to convert to scottrade pro to do those type trades. hopefully other investors that use scottrade will call and voice a complaint and possibly scottrade will change their policy.

    Roland

    • Alan Ellman February 2, 2017 6:01 pm #

      Roland,

      Brokerages are under more scrutiny than ever to protect retail investors like you and me. Specifically, they are required to abide by the KYC (know your customer) rule. They are subject to fines and legal action if it is deemed they permitted certain investors to use trading strategies beyond their capabilities or financial means. Brokerages have compliance departments that make determinations which strategies are permitted and have a list of criteria that must be met.

      The bottom line here is that Scottrade deems covered call writing appropriate for a lower level of trading approval than spread trading which is very common as I mentioned in the webinar. This can be viewed as a positive or a negative for us but generally it is a positive based on some of the emails I receive from investors who were too quick to use a new trading strategy before learning the ropes.

      Now I know this would never happen to you based on your history at BCI but you’d be surprised how often investors get hurt by biting off more than they can chew.

      Alan

  12. Georgia February 3, 2017 8:31 am #

    I have two accounts, a trading account and a long term investment account that includes mutual funds, index funds, & exchange traded funds. What is your opinion of having mutual funds, index funds and exchange traded funds as an investment strategy?

    Georgia

    • Alan Ellman February 3, 2017 11:28 am #

      Georgia,

      The securities you mention can be utilized in various ways depending on our goals and personal risk tolerance.

      I love low expense ratio broad market index funds for long-term investing or for building up portfolio value in preparation for option-selling. I discuss this approach in great detail in my book, “Stock Investing for Students” Mutual funds cannot be used with options but many ETFs can be part of our covered call writing portfolios. I use these in my mother’s account.

      So yes, index (mutual) funds and ETFs can be a significant part of our investment strategy as long as all aspects of that particular strategy are mastered.

      Alan

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