One of our covered call writing exit strategies is the mid-contract unwind (MCU) exit strategy. We generally implement this approach when share price accelerates significantly leaving the short call deep in-the-money (ITM).
Breaking down the components of a deep ITM strike
As the strike moves deeper in-the-money as share price rises, the time-value component of that option premium approaches zero. However, the intrinsic-value component will rise. The actual cost-to-close (CTC) will be substantial but the time-value cost-to-close will be minimal. We use the unwind now tab of the Trade Management Calculator, Elite and Elite-Plus Calculators to perform these calculations which assists us in evaluating these potential exit strategy opportunities.
Why is the intrinsic-value component of a deep ITM strike negated when we sell the shares?
When the short call is in place, our shares are worth the strike price due to our contract commitment to sell at that price. When we buy back (buy-to-close or BTC) that call option, the shares are now worth current market value. This bought-up value of our shares negates the intrinsic-value facet of the cost-to-close.
A real-life example with NVDA (per-share trades)
- 10/20/2021: Buy NVDA at $221.47
- 10/20/2021: Sell-to-open (STO) the 11/19/2021 $225.00 call at $7.25
- 11/5/2021: NVDA trading at $311.91
- 11/5/2021: Close the 11/19/2021 $225.00 call at $87.35
Initial trade structuring
NVDA Calculations on 11-5-2021
The initial 1-month time-value return is 3.3% if the trade lasts through contract expiration (11/19/2021- yellow cell). There is an additional upside potential of 1.6% (brown cell) if share price rises past the $225.00 strike (and it certainly did). The trade was setup for a maximum potential 4.9% 1-month return.
Calculating the time-value only cost-to-close using the unwind now tab
NVDA Time-Value Cost-To-Close
Although the actual CTC is $87.35, the actual time-value component is only $0.44 per-share as the intrinsic-value aspect is $86.91 (the amount the strike is lower than current market value).
Discussion
If we close this trade mid-contract, the initial trade structuring maximum return is lowered from a 1-month 4.9% return to a 16-day 4.7% return. The cash freed up when the shares are sold can be used for a second income stream in the same contract month.
Your generous testimonials
Over the years, the BCI community has been incredibly gracious by sending our BCI team email testimonials sharing stories as to what our educational content has meant to their families. Moving forward, we have decided to share some of these testimonials in our blog articles. We will never use a last name unless given permission:
To BCI:
GREAT SITE, GREAT KNOWLEDGE.
CAN’T WAIT FOR THE NEW CALCULATOR.
Jeff
Upcoming events
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Hi Alan,
Do you have a video on hedging an entire portfolio or would you be interested in sharing thoughts to the subscribers?
Jeff
Jeff,
There is a difference between hedging as retail investors and hedging as portfolio managers.
In our BCI methodology, retail investors hedge risk by:
1. Selling options which lowers our cost-basis.
2. Strike selection which determines the risk inherent in our trades.
3. Rigorous screening for elite-performers.
4. Position management to mitigate losses and enhance gains.
5. Diversification.
6. Cash allocation.
Portfolio managers will mitigate market risk by seeking close to Delta-neutral portfolios. This is where long and short stock & option positions have a net value close to “0”
Here is a link to an article I published on this topic:
https://www.thebluecollarinvestor.com/what-is-a-delta-neutral-portfolio-a-real-life-example-with-inmode-ltd-nasdaq-inmd-free-webinar-registration-links/
Alan
Hi Alan
Thanks for the many educational videos published on covered-call writing.
I have a question regarding portfolio overwriting and the benefit from selling options into higher implied volatility.
What are you looking for when selling covered calls as part of a rather passive portfolio overwriting strategy. In one of your webinars you mentioned 6%, but I guess that’s in very low-volatility environments. Right now, with a lot of stocks trading sideways for >1 year, you can get 1.5% ROO with 5% to 7% upside potential. I’m talking about MA, ORLY, UNH, TMO… stocks that are in my parents’ account for the long run.
We want to utilize the premiums to partly re-invest it and spend it on vacations, dinners et cetera. So my question is: in a world of increasing volatility, is 1.5% on blue chip stocks sustainable, on top of plentiful upside potential (to circumvent negative tax issues)? What are your thoughts on this over your 2+ decade experience as an option seller?
Many thanks in advance!
Best
Hamish
Hamish,
There is a tradeoff with higher IV which results in higher premiums but greater chance of a strike expiring ITM. One way to analyze these situations is to look at the Delta of the strikes. This gives us an approximation of the probability of that strike expiring in-the-money or with intrinsic-value.
Let’s look at one the holdings you alluded to in your question, MSFT ($272.99). The screenshot below shows the following:
To achieve an initial return of 1 1/2% ($4.00), we would look to the $295.00 strike which has a Delta of 24.88%, about a 25% probability of expiring ITM and resulting in exercise with no exit strategy intervention.
To achieve an initial return of 1/2% ($1.35), we would look to the $310.00 or $315.00 strikes which have Deltas of 11.77% and 8.97%.
We base our final decisions on the tradeoff these 2 factors.
CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.
Alan
Hi Alan,
I want to understand risk assessment. Do you have any information that speaks to this or will you please explain risk assessment when selling covered calls. What I mean is would it be advisable to purchase a large amount of shares of one asset in order to sell more calls to possibly increase monthly income. What would be the risks associated with doing this?
Thanks Alan.
Tanya
Tanya,
Covered call writing lowers our risk of stock ownership. This is why we are willing to cap the upside.
If we purchase a stock at $48.00, this is our cost-basis or breakeven price point. If we then sell a $50.00 covered call option for $2.00, our breakeven price point is lowered to $46.00.
That said, when we purchase shares for a covered call writing portfolio, we must have diversification and cash allocation in mind because there is enhanced risk by being in a small, percentage of stocks or industries (sectors). If that stock or industry falls out of favor with the institutional investors our entire portfolio suffers whereas if we were well-diversified, allocating a similar amount of cash per-position, we will have the other securities to mitigate.
Bottom line: Covered call writing lowers our risk, but diversification and cash allocation must be part of our plan.
Alan
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 04/22/22.
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The BCI Team
Hi Alan,
I am a BCI member and have a quick question regarding strike price selection for covered calls. If a stock price is halfway between ITM and OTM strike prices, with nothing available ATM, how do you decide which strike to choose? The following examples are listed in the 04/22/22 Stock Screen and Watchlist:
• SMPL: latest price 42.25, 40 and 45 strikes available
• MLI: latest price 57.34, 55 and 60 strikes available
I’m assuming you’d just write an OTM call in these circumstances, given the technical/fundamental signals look good?
Thanks for your time,
Andrew
Andrew,
I am responding pre-market on Monday. I always recommend entering new trades between 11 AM and 3 PM ET to avoid early morning and late afternoon volatility created by institutional computerized trading.
In the screenshot below, using our new Trade Management Calculator, I highlighted the ITM $40.00 strike in brown and the $45.00 OTM strike in green.
We would favor the ITM strike to take a more defensive position, resulting in a 26-day return of 1.88%, 26.32% annualized. The trade offers a 5.33% downside protection of that 1.88% profit.
A more aggressive approach would be the $45.00 strike which generates an initial return of 1.30%, 18.27% annualized, with an additional upside potential of 6.51%
Aggressive or defensive? In the current market climate, most comfortable trading would favor the ITM strike but this is a decision for each individual investor.
Recheck the stats at 11 AM ET.
CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.
Alan
Alan,
We hope to see the market rebound this week, but we are indeed in a bear mood.
I have tried to pick a few safe tickers for my 05/20 CC trades and observed that all the one-year charts are steadily trending down.
At this point, I am 50% invested, but I am seriously considering liquidating all my trades and staying in cash until the market begins to change direction.
Roni
Reposting what I posted late last week in the BCI blog. The attached image has ben improved.
** 4/21/22 zzmg
** How I Process a BCI Mid-Contract-Unwind (MCU) – Setting up a Limit Order to Unwind a position with a Guaranteed Percent Loss of the Strike **
Section 1 – Strategy and Formulas
When the stock in a covered call position rises up quickly during an expiration cycle, the goes deep in the money (ITM) and the time value of the option approaches zero or a low value.
The BCI methodology for this scenario is to perform a Mid-Contract-Unwind (MCU) which unwinds or closes the position at a certain cost to close (low loss) so you can use the released cash to buy a different stock and sell a covered call option for a second stream of income. You do not unwind the position unless you have open a new position that has at least a 1% additional gain above the loss of the closing trade. If you a 1% closing loss, then the new position should provide at least 2% Gain. For a 0.1% loss, your new position should have at least 1.1% gain.
You can use the Elite Calculator Unwind Now tab to calculate your loss and % loss, or as I will explain later calculate it and setup a limit order with a guaranteed percent loss.
My initial strategy is to setup a limit order (closing buy-write covered call) to guarantee a 0.1% loss initially, then work on the trading plan as the position develops. On a $20,000 investment that is $20.00. On the opening bell or market surge during the day, the limit order may fill successfully..
When you set up a limit order for the MCU, you are setting your limit order at a value Stock Price – Option Premium. When order executes successfully your cash position in your portfolio is increasing by the surged stock price and decreasing by the Option Premium (Buy to Close order).
Since the stock price is greater than the option premium, the difference is always positive (credit order) and increases your Cash. No matter what price the stock goes to or the Time Value of the option decreases to, the best you can do is increase your cash position by the strike price. Your gain or profit/loss is limited or protected by the strike price, as I will show below.
See attached drawing.
For a stock and it’s stock option, the relationship between the Stock and the Option premium is:
(A) Stock price = Intrinsic Value + Strike
(B) Option Premium = Intrinsic Value + TV (Time Value)
Notice on the left side above the two variables are the Limit Order values. Subtracting formula B from A, you get
(C) Stock Price – Option Premium = Strike – TV
The left side is your limit order. The right side says if TV = 0, the best you can do is increase your cash position by the strike value. It also says if TV is not equal to zero, your cash is reduced by the Time Value or a percentage of the Strike, which is your cost to close. You can show this as follows:
If you let TV= Per * Strike where Per is the percent of the strike then:
(D) Stock Price – Option Premium = Strike – (Per * Strike) where Per = TV / Strike or the time value TV is a percentage of the strike.
Since the left is the limit order values, then
(E) Limit Order =Strike – (Per* Strike)
Section 2 – Setting up Limit orders
For a covered call position with strike 71:
** For a 0.1% closing loss, the credit limit order should be to.
Limit order = 71 – ((.001) * 71) = 71 – .071=70.929
** For a 1% cost to close or closing loss:
71 – .71 = 70.29
Regards,
Mario G.
Mario,
This is a reasonable approach to automating the MCU exit strategy especially for those who want to set a net credit limit order with a specific time-value loss using a buy/write combination form.
Thanks for sharing this well thought out graphic analysis.
Alan
Alan,
Do u still use the 20%,10% guideline or the 7% exit strategy in a downturn like the one we’re going thru now.
Donald
Donald,
Yes. My position management techniques remain the same in all market conditions as there are specific actions we take based on our defensive of aggressive determinations.
Having exit strategy maneuvers for all situations that arise, and adhering to these rules and guidelines, will allow us to take emotion out of our investment decisions. Some market conditions can be quite challenging but panic is never a solution.
Alan
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Alan and the BCI team