Option contracts can be standard or adjusted. Certain corporate events may change standard option contracts to adjusted contracts. These events include stock splits, mergers, acquisitions, special dividends, spin-offs and reverse splits. After these events, options are altered to reflect these changes and make buyers and sellers of options whole. This article will focus in on reverse stock splits.
What is a reverse stock split?
A reverse stock split results in the reduction of outstanding shares and an increase in the price of the underlying security. The holder of an option contract will have the same number of contracts with an increase in strike price based on the reverse split value. The option contract will now represent a reduced number of shares based on the reverse stock split value.
Why corporate boards approve reverse splits
When share price declines substantially, the stock may be viewed as a low-quality investment. A reverse split increases share price for cosmetic appeal. Also, companies may fear exchange de-listing of a stock if it fails to maintain the threshold required price.
Real-life example with SPDR S&P Oil & Gas Exploration & Production ETF (NYSE: XOP)
XOP Price Decline from over $100.00 to $31.00
Option Clearing Corporation (OCC) explanation for XOP 1-for4 reverse split
XOP Contract Adjustment on 3/30/2020
Takeaways:
- Share price quadruples
- Number of shares deliverable per contract and owned is quartered
- Ticker symbol changes
Discussion
Reverse splits are generally signs of weakness. These corporate events enhance the cosmetics of share price without changing to overall value of the security. Option holders and sellers are made whole by the OCC by altering one or more of the contract parameters. In the case of XOP, the number of shares were reduced by a factor of 4 while share price increased by that same factor. Generally, stocks that undergo reverse splits are not ideal candidates for covered call writing and selling cash-secured puts.
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If you would like to schedule a private webinar with Alan and Barry, send an email to:
Include:
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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:
Hi Barry,
Thank you so much for responding to my questions.
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Upcoming events
1. How to Set Up a Covered Call Writing Portfolio Using Stock Selection, Option Selection and Position Management
Step-by-step analysis using the Elite-Plus Calculator
Hosted by:
Dr. Alan Ellman, President of The Blue Collar Investor Corp.
Barry Bergman, BCI managing Director
The initial structuring of our covered call writing portfolios is critical to achieving the highest returns. Once established, we move to position management mode.
This class will start with option basics, define covered call writing and detail the 3-required skills that will allow us to become elite covered call writers… stock selection, option selection and position management.
Real-life examples will be analyzed describing how the stocks and options are selected as well as how to set up the overall portfolio based on cash available, strategy goals and personal risk-tolerance. Various spreadsheets will be used to simplify the process.
An introduction to the initial step in position management will also be addressed. This class is for beginners to sophisticated option traders. There will be something for everyone.
Time: Oct 15, 2020 08:00 PM Eastern Time (US and Canada)
Join Zoom Meeting
Meeting ID: 940 8782 0438
2. Wealth 365 Summit (free)
I was invited do host a two 1-hour webinar on
Monday October 12th at 10 AM ET and 7 PM ET
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Market tone data is now located on page 1 of our premium member stock reports and page 1 of our mid-week ETF reports.
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Hello Alan and good morning!
I wanted to first tell you that I landed on your web page about a month ago and your honest free advise made me a subscriber of your content. Thank you for putting this information out as you have provided a lot of free advise that is very helpful.
I am very familiar with covered calls (I learnt it initially from Motley Fools Options program) and I like your screening service to help pick the stocks.
I did have one question, if you can please give me your opinion.
What I learnt at Motley Fool was was to play options, beside covered called, you can also do Leaps. I know this is more risky and needs another level of auth from a broker than the safer covered call strategy.
However, I plan to get leap calls on the base stock and then play the sell call on it. So instead of buying the actual stock, I was planning to buy a LEAP call and then play your underlying option sell call on it.
What is your opinion on this, as I would love to hear back from you on this?
Thanks and have a great day!
Dashant
Dashant,
The strategy you are describing is known as the “Poor Man’s Covered Call(PMCC)” or, technically, the long call diagonal debit spread. We buy deep ITM LEAPS and write short-term calls against those long positions.
Far too many retail investors consider this strategy “covered call writing, but cheaper” This simply is not true. There are a multiplicity of moving parts the PMCC that must be understood and mastered before we can make a decision if this is the right strategy for our families. If the answer turns out to be “yes” then we now have the tools to be successful.
An advantage of this strategy over traditional covered call writing is that less capital is required to enter the trade. A disadvantage is that we are required to make a long-term commitment to a stock which reduces opportunities to reassess our bullish assumptions. There are many more pros and cons.
For more information of the PMCC strategy:
BOOK:
https://thebluecollarinvestor.com/minimembership/covered-call-writing-alernative-strategies/
Online video course:
https://thebluecollarinvestor.com/minimembership/video-poor-man-covered-call-program/
PMCC Calculator:
https://thebluecollarinvestor.com/minimembership/poor-mans-covered-call-calculator/
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 10/09/20.
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
On the front page of the Weekly Stock Report, we now display the Top 10 ETFs, the Top Performing SPDR Sector Funds, and the 4 single Inverse Index Funds. They are sorted using the 1-month performances from the Wednesday night ETF report and the prices from the weekend close.
Best,
Barry and The Blue Collar Investor Team
[email protected]
Edit
Alan,
I was just looking over the stock report that came out last night. Some stocks (like AMRC) have been on the list every week this contract. This one has a mixed technical chart but all other boxes are checked. How do we decide if we use itm or otm options if we choose a stock like this one?
Thanks as always,
Marsha
Marsha,
When one of our eligible stocks has mixed technical indicators, we base the “moneyness” of our options on overall market assessment. We favor ITM strikes if we prefer more defensive positions and OT
Hi Alan,
I am enjoying your books on selling calls and puts and have been using your methods on paper trading.
I have a question about exit strategies. I know you favor monthly options but I have entered a few weekly option trades and wondered how your exit strategies of 3, 10 and 20% apply… do I use the same strategies as I would if they were monthly but just mid week and expiration day?
Thanks so much!
Joni
Joni,
For covered call writing Weeklys, we use the 10% guideline as we would had we sold a Monthly and now find ourselves in the latter part of a contract.
For puts, the 3% guideline holds for Weekly as well.
Alan
Hello Alan
Thank you for your webinar, I found it very useful.
I have a question. Your colleague Barry wrote in the chat box that you avoid the weeks when a company announces its earnings report. I commented that I have a few times bought a put and a call a week or two before these events and found, quite reasonably that one goes up and the other goes down. I decide to close the down transaction quickly and let the other one ride for a few hours and then close it. Your colleague said you are conservative traders and avoid such high risk situations. My question is are you going to stay out of the market during election week?
Best regards
Jeffrey
Jeffrey,
Avoiding earnings report is a critical rule in the BCI methodology. Covered call writing and selling cash-secured puts are conservative strategies where capital preservation is a strategy goal. Earnings reports represent potential risk to the downside.
I am currently 50% in cash and my plan is to move to a minimum of 80% cash prior to the election. No right or wrong here… simply reflects my level of risk-tolerance. Your analogy is a good one as the election represents potential risk similar to earnings reports.
Alan
Hi. Alan,
I have gone thru the 2 covered call books and the DVD set ($199). I must say excellent compilation of material. It is as simple as ABC and played out excellent. The pace of the course is just fine so that it is not overwhelming.
I have a few questions and clarifications.
1. You have called for diversification and as I understand, buy 5 different stocks in 5 different industries, making a lot purchase of the portfolio for Covered Call Writing for the month only containing 5 or 25 different stocks in total?
o 5 different stocks (1 x 5industries =5)?
o Or 25 different stocks (5x 5industries = 25)?
2. When PAPER TRADING you’ve called for using the initial balance as the starting as the initial real money balance. If I want to start with let’s say a 500K account, will I still buy only 5 or 25 stocks in the portfolio for the given monthly option cycle? Just a bigger lot number? Or maybe go in for more stocks from the premium membership list?
3. The realistic goal for me is 3% a month. How much deviation have you seen from that in these current market times? I have no particular desire to hold any stock. For me the goal is monthly near predictable returns so I can tailor my expenses and expectations likewise.
Best regards,
Randy
Randy,
Thank you for your generous comments.
My responses:
1. The minimum requirement is 5 different stocks which are located in 5 different industries… so the requirement is 5. Using ETFs will allow us to use fewer positions for proper diversification. For example, if we owned 3 Select Sector SPDRs, we would own approximately 27% of the S&P 500.
2. Start small and work up to $500k. Paper trade (let’s say) $100k with 6 to 8 stocks. This will give you an idea of your comfort level regarding the number of positions you can manage without becoming a hardship. Work your way up from there and ultimately you will know your “sweet spot” For me, it’s 15 – 25 positions resulting in 50 -100 contracts per month plus a few in my mother’s portfolio. We each must find our own comfort level.
3. We start with initial trade structuring and manage our trades from there. I have a similar 2% – 4% per month initial time-value return goal range. Final results can be more or less depending on market movement. Once we master the 3-required skills, we have the tools to beat the market on a consistent basis, substantially in many years.
Alan
Hi Alan!
Thanks for the quick reply.
I have a few quick questions on understanding the trading methodology.
When I start with a $100K paper account, with the aim to work it up to $500K, you have suggested that I use 6 to 8 stocks, to get comfortable with entering and managing the trades.
When I take the next steps, let us say to 200K, then 300K then 400K, 500K so on in paper trade, My Questions are:
1. I’m still in 6-8 stocks, just larger positions, or I am in more stocks (of course diversified)?
2. Do I employ all OTM, ITM, and ATM calls, as you have mentioned laddering up?
As a PREMIUM REPORT SUBSCRIBER I have access to the first part (Stock Selection).
• My question is: For OPTION SELECTION I’m using the Ellman Calculator to select the options for the 2-4% initial time-value return?
Best regards,
Randy
Randy,
My responses:
1. If you are comfortable with 6 – 8 securities, add a few more, perhaps up to 8 – 10. As you increase portfolio size, add additional securities until you locate your comfort level. For me, it’s 15 – 25 positions which translate to 75 -100 contract per month plus a few in my mother’s portfolio. We set ourselves up for success by creating a portfolio that aligns with our comfort levels.
2. The “moneyness” of the strike is based on overall market assessment, chart technicals and personal risk tolerance. OTM is more aggressive and ITM is more defensive. Laddering strikes is an effective way to balance risk. If unsure, favor the more defensive approach until you find the best approach for your trading style… it won’t take that long.
3. The Ellman calculator will tell us if the time-value return, upside potential and downside protection meets our strategy goals. I look for 2% – 4% per month for my initial time-value return goal range; 1% – 2% in my mother’s more conservative portfolio. One size does not fit all.
You’re doing a great job doing your due diligence as you enter your option-selling career.
Alan
Good Morning Alan,
I was wondering if you might have time to review a recent trade I placed which leads to a question about ITM strikes. In general, if we sell ITM call options, we should use the unwind now calculator regularly to monitor the position. Is that a fair assumption? And if we have more than one contract, the unwind now calculator simply calculates the results for just one contract so simply multiply the results by the number of contract held correct?
I feel like I may have an example of an unwind now setting up with JD. I bought 200 JD on 10/6 at 76.94 and sold two ITM 11/6 75C for 5.12. As of this morning, the stock has appreciated to 83.36 and the ask for the 75C would cost 9.35 to close the position. )See screenshot)
Is this a candidate for looking to roll up in your opinion or would you sit on this for another week? Thank you in advance for any guidance or opinion you can offer. Have a nice day.
Regards,
Patrick
CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.
Patrick,
When a strike moves deep in-the-money, you are correct to monitor the trade with the “Unwind Now” tab of the Elite and Elite-Plus Calculators. However, we monitor for mid-contract unwind exit strategy opportunities, not rolling the option. The calculator will give both percentage as well as total portfolio cost-to-close stats.
At the end of a contract, with a strike in-the-money (ITM), we use the “What Now” tab of the calculators to assist us with our trading decisions.
In your very successful trade, your initial structuring was for a 4.2% 1-month return with 2.5% downside protection of that time-value profit. Now, with the strike deep ITM, the calculator shows a 1.32% time-value cost-to-close. We ask ourselves if we can generate more than a 2.32% return by current contract expiration by closing the entire position and entering a new one with a different stock. In this case, it’s a close call. Frequently, the best action is no action at all and continue to monitor our trades.
Keep up the good work.
Alan