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Buy A Stock And Wait Before Selling The Option: Is This A Good Strategy?

The goals of covered call writing include generating monthly cash flow and preserving capital. We use every fundamental, technical and common sense principle available to maximize our profits and protect our cash. Paul A. recently sent me an excellent question that motivated this article:

“…if the market has a down day and drags down the price of the stocks I am interested in, is it reasonable to buy the stocks and wait a few days in hopes the market will tick back up and allow me to generate higher option returns”

You can tell from the inquiry that Paul is a seasoned investor. Frequently, the overall market direction will cause a price decline in outstanding performing stocks and should the market recover, these elite stocks should come back with a vengeance. Let’s first list the three things that can happen to the share price after the long stock position is entered:

  • Price goes up
  • Price goes down
  • Price stays the same

The price goes up

Paul’s strategy works like a charm. The price increase leads to an increase in option premium and the trade turns out more profitable than had the option been sold when the shares were purchased.

The price goes down 

This time the strategy does not have a happy ending. The option premium generated will be less and in some cases we may have to write for a lower strike price in order to generate the returns required by our initial goals (2-4%/month in my case). I addition to that, we have capital depletion due to a lower share value. Exit strategy execution should help mitigate losses.

The price stays the same

On the surface it may appear that in this situation there is no harm, no foul but that’s not the case. Despite the fact that the price remains the same, the option value will decline in value (assuming implied volatility remains the same). This is because of theta or time value erosion of the option premium. Every day that passes will result in time decay of the option premium and that decay will accelerate as we move later into the contract. Theta is not linear, it is logarithmic and starts off slow and then eventually “falls off a cliff”.  Here is a graph showing theta’s impact on the time value of an option premium:

Time value erosion of option premiums

Theta and covered call writing premiums

 

In 2 of the 3 scenarios, we lose. These are odds I try to avoid. By selling the option at the time we purchased the security, we will generate the returns that meet our goals or we would not have selected that underlying. That being said, there are tactics we can employ to take advantage of this situation without incurring the risk suggested. We do survey the overall market and, if bullish, we can favor out-of-the-money strikes. What this accomplishes for us is that we generate the initial profit that meets our goal and then have the opportunity for an additional income stream from share appreciation up to the strike price. For example, if a stock price had dropped from $30 to $28 and we purchased it at that lower price, we can immediately sell the $30 out-of-the-money call. Let’s assume we generate $0.90 per share or $90 per contract for an initial 1-month return of  3.2% Not bad so far. Now, since we are bullish on price movement (inherent in Paul’s question) we anticipate a price increase. If the price does move up to the $30 strike, we generate an additional $2 per share or $200 per contract. In this scenario our total 1-month profit is $290 on a cost basis of $2800 or a 10.4% 1-month return.

Conclusion:

After a market decline and shares are purchased at a lower price, it is to our advantage to immediately sell the option to generate our target goal. If we are bullish on the overall market anticipated movement, we can take advantage of that situation by favoring out-of-the-money strikes. This way we are guaranteed our initial target returns and have an opportunity to take advantage of a market recovery. Of course, we always are prepared with our exit strategies if any trade turns against us or turns out much better than expected.

 

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Market tone:

As we recover from the extreme winter conditions this economy has endured, market expansion is picking up:

  • The central bank’s Beige Book reports expansion in 10 of its 12 districts
  • The Federal Reserve reports that employment is growing @ a moderate pace. It also reported that overall economic activity expanded at a modest to moderate pace from mid-February to the end of March
  • In March, retail sales increased by 1.1% (0.8% was predicted by analysts) as February stats were adjusted upward from 0.3% to 0.7%. The March gain was the largest increase in 18 months and 3.8% better than the previous year
  • According to the Commerce Department, Business Inventories (a report of the dollar value of product inventories held by manufacturers, wholesalers, and retailers. Included in the report is the inventories/sales ratio, a gauge of the number of months it would take to deplete existing inventories at the current rate of sales, which is an important indicator of the near-term direction of production activity) rose by 0.4% in February
  • In March, new housing starts increased by 2.8% to a rate of 946,000. However, permits for future projects fell
  • According to the Labor Department, initial jobless claims for the week ending April 12th came in at 304,000, below the 311,000 anticipated
  • According to the Federal Reserve Board, US industrial production increased by 0.7% in March as February’s stat was revised upward to 1.2%, twice the original figure. Analysts predicted an increase of 0.5%

For the shortened week, the S&P 500 rose by 2.7% for a year-to-date return of 1.4%, including dividends.

Summary:

IBD: Market in correction

BCI: Moderately bullish on our economy but keeping a defensive posture due to geo-political concerns and favoring in-the-money strikes 2-to-1

Happy holidays to one and 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.

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9 Responses to “Buy A Stock And Wait Before Selling The Option: Is This A Good Strategy?”

  1. Barry B April 19, 2014 11:57 am #

    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 04-18-14-RevA.

    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/

    Best,
    Barry and The BCI Team

  2. Alan Ellman April 19, 2014 12:30 pm #

    To our new premium members:

    The BCI team welcomes you to our growing community of premium subscribers.

    Since we are in the heart of earnings season I wanted to point out the eligible candidates for the first week of the May contracts:

    You will note that many of the otherwise eligible candidates are located in “gold” cells of the running list (middle of the report). These stocks are not eligible until the reports pass and are highlighted as such so are members are aware to avoid them until the ERs pass.

    So what is eligible?

    – the 8 stocks located in the “white cells” of the 2nd page of the running list
    – the 27 ETF candidates found in our most recent ETF Report dated 4-16-14
    – The first 7 stocks on the running list that are located in the gold cells report during the first week of the contract and as long as we don’t see a dramatic price decline after the report will become eligible and allow us to capture 3+ weeks of time value

    Earnings season does present a minor challenge to covered call writers but nothing we can’t overcome.

    Alan

  3. Jay April 20, 2014 8:52 pm #

    Paul,
    I reached your same conclusion last year. I found if I bought Alan and Barry’s picks more often then not they went up. So an immediate write locked me in too soon. I would have done better not writing at all or at least waiting in most instances. But how many 2013’s does the market hand us :)?

    Thus my “buy/wait” strategy during uptrending markets. The other nuance is “buy/write half”. This assumes you take positions of at least 200 shares. That way if a stock takes off you are not left completely at the bus stop.

    We have a different market this year. More conducive to classic call writing.

    Best regards and results to you, – Jay

  4. Dan S. April 22, 2014 3:56 am #

    Interesting question. I have been with BCI about 9 months and I too have had the same question. Over time, and with experience, you will realize that Alan’s response is spot on.

    You can’t predict the future and should not even try. Sell your call when you buy the stock. You know at the time exactly the premium you will receive….the risk of waiting is too high.

  5. Adrian April 22, 2014 6:25 am #

    Alan, thanks again for your answers last week, I couldn’t thank you sooner because been I had away over easter period. Hope yours was ok as well!
    Now I first need to readdress a past question to you, this was the 4th one of your last article I asked:-
    – If you have already bought a stock, and have sold a call option, and now the price has gone down to meet the 20%/10% buyback value, and so you buy back the option.
    But because the price has gone down quite a bit and also consolidating then do you still sell ITM options, or are you in hope of the price to go up and so sell OTM options?
    Does it depend on how far the price has fallen? (a bit like after a gap-down?)

    Also my 2 questions as I promised to ask before about VIX and sentiment I have are:-
    2. How many times during the monthly contracts do you need to check the VIX for any of your stocks?
    3. And how often am I to check the market tone reports on your website? I am thinking every week, but market may deteriote between each update from news,- in which case shouldn’t we need to then do our own research on what made market fall/rise?

    I vaguely know what I may have to do for my first question, but still need the comfort that I am thinking this correctly. Thanks

    • Alan Ellman April 23, 2014 11:16 am #

      Adrian,

      My responses:

      1-The premise here is that the stock gaps down and we decide to keep the stock. This implies that our assessment is for a recovery and so selling OTM strikes (relative to current market value, not original purchase price) makes the most sense.

      2- The VIX is a measure of the volatility of the overall market. I check that weekly. Implied volatility of individual stocks is evaluated when we are doing our calculations…the higher the % returns, the higher the IV. My sweetspot is 2-4% per month as a guideline. Once the trade is entered, it is managed as detailed in my books/DVDs and there is no reason to go back and re-assess the IV of the underlying.

      3- I publish the BCI and IBD market tone weekly in my blog articles. This will not change dramatically mid-week unless there is an unusual event. As a general rule, you should have an idea of your overall market assessment when you are executing trades…either the initial trades or exit strategy execution.

      Alan

  6. Bob April 23, 2014 10:27 am #

    I always sell the call immediately upon buying the stock. The only knowledge you have about the market is what you know right now, not what it might do tomorrow. Take what the market gives you today.

    • Paul June 29, 2014 9:46 pm #

      I’ve had some luck when buying stocks on the Monday after expiration Fridays and the stock I want is down. If I wait a day or 2 it more often than not has ticked back up and then I sell the call. Also, if I can’t get my price when I try to sell the call immediately I can get it sometimes the next day. If the stock keeps going down I sell it, take a small loss and use my money elsewhere. This strategy won’t work when buying stock on an up day. Overall, this minor wrinkle has slightly increased my returns.

      • Alan Ellman June 30, 2014 12:07 pm #

        Paul,

        Thanks for sharing this information. I know there are other BCI members who use a similar approach. We have many members that use different “wrinkles” in the BCI methodology and I encourage thinking outside the box.

        An alternative is to use OTM strikes so you can take advantage of future share appreciation and not have the deleterious impact of theta (time value erosion) on our option positions as we wait for share price to rise.

        In addition, if we wanted to enter a covered call position at a lower than current price, we can sell OTM cash-secured puts first. I will be detailing this strategy in my upcoming book on put-selling.

        Thanks again for sharing your experience with our BCI community.

        Alan

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