Exit strategies or position management is one of the three major components of this strategy we must master to become elite covered call writers. The other two are stock (or ETF) and option selection. In my books and DVDs I mostly focus on scenarios that can result in losses and how to mitigate those losses or turn them into gains. However, there are times we need to take action when the trade turns out to be much better than we anticipated…a short-term acceleration in price. I refer to this strategy as the mid-contract unwind exit strategy. With the market rebounding significantly recently opportunities have been created. Several of our members (we have a very smart group I’m proud to say) have recognized these favorable circumstances and inquired as to the best time to close a position when share price rises substantially in a short time frame. These inquiries motivated this article.
If we purchased a stock @ $48 and sold the $50 call for $1.50, we generated a 3.1% initial option return. If share price moves up to $60 in the first half of the contract, we have another $2 in share profit ($48 to $50, the strike price). That is a 7.3%, 1-month return and appears to be maxed out because there is no benefit to us if share price rises higher due to our option obligation to sell @ $50. The only way we would not achieve maximum returns on this trade is if share price drops > 10 points to under $50.The BCI guideline as it relates to the mid-contract unwind exit strategy is to always close the entire covered call position (short option and long stock) when the time value component of the option premium approaches zero in the first half of a contract. When an option is trading @ intrinsic value only it is said to be trading @ parity.
Let’s look at a real-life example taken from the recent Premium Watch List dated 10-24-14. The stock is JAZZ Pharmaceuticals. Here’s the trade:
- 10/20: Buy JAZZ @ $152.26
- 10/20: Sell $155 OTM call @ $3.35 for a 2.2%, initial 1-month return (share profit = $2.74/share)
- 10/20: Max profit achieved = 4%
- 10/30: JAZZ is trading @ $168.36
- 10/30: $155 call’s last trade was $13.35 with intrinsic value of $13.43
Here is a linear price chart of the $155 call option showing initial and current values:
Next, we will review the options chain for JAZZ on 10-30-14:
If we can execute the trade to close our short position at or near $13.43, it will meet our requirement to close when time value approaches zero. Let’s assume we can close for $13.50, an amount above the last trade. Of that $13.50, $13.43 is intrinsic value, the amount the $155 strike is in-the-money. In this case we have an option debit of $13.50 to close but a stock price credit of $13.43 because we are no longer obligated to sell @ $155. Our net cost to close (excluding commissions) is $0.07 or $7/contract. When the shares are sold, we have maxed our initial trade in the month (November contract in this case), less $7, and have now freed up all the cash from the stock sale to initiate another covered call trade in the same month with the same cash. We have two incomes streams from this same cash amount. To make this a successful exit strategy, all we need to do is generate an amount greater than $7/contract.
When share value rises significantly in the first half of an option contract after entering a covered call trade buy back the option when its time value component approaches zero and the amount that can be generated in a subsequent trade exceeds the debit incurred in closing the initial trade.
Put Book Update
I have approved the final edits and the artwork for the covers. The book is now in the hands of the publisher for formatting. I expect that the book will be available to our members by the second half of November. I will have my team send out notification to you for early order discounts before it is available to the general public on Amazon.com:
Upcoming live seminars (click on city for more information)
Saturday, November 8th
Friday, November 21st
The positive impact of a strong earnings season was magnified on Friday by a surprise decision by the Bank of Japan to enhance its stimulus measures. Concerns continue regarding a weakening global economy and a strengthening US dollar which may negatively impact exports:
- The Federal Reserve Board announced the end of its bond-buying program and maintained its stance that short-term interest rates would remain near zero “for a considerable time” Rates have been set between 0 and 0.25% since 2008
- The Fed also noted improvement in the labor market and the economy in general
- Personal income increased by 0.2% in September, the 9th consecutive monthly gain
- Personal spending dipped by 0.2% as economists were predicting an increase of 0.1%
- The Employment Cost Index (measures the price of US civilian labor) rose by 0.7%, beating analyst’s predictions of 0.5%
- According to the Commerce Department, Real Gross domestic product (GDP) for the 3rd quarter on an annualized basis came in at 3.5%, well above the expected 3.0%
- GDP is up 2.3% year-over-year
- The Conference Board’s Consumer Confidence Index rose from 89.0 to 94.5 in September, attaining its highest level since 2007
- Durable Goods orders in September declined by 1.3%, the 2nd straight monthly decrease
For the week, the S&P 500 increased by 2.7%, for a year-to-date return of 11.0%, including dividends.
IBD: Confirmed Uptrend
GMI: 6/6- Buy signal as of market close on October 27, 2014
BCI: Moderately bullish favoring out-of-the-money strikes 2-to-1
My best to all,
Alan ([email protected])
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 10-31-14.
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:
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:
Barry and The BCI Team
I always want to sell only deep in the money calls (DITM) since I’m only worried about downside protection. Is there any way to find high beta/high volatility strong stocks which will be good candidates for this strategy?
Example from Oct 31st Weekly Stock Screen: AMBA is a candidate for doing a covered call with the Nov. 22 strike of 45 would return 4.2%, along with 1.6% upside potential. (Stock at 42.29). Instead, for downside protection, what if I bought the stock, and sold the Nov 22nd, $24 strike, which would net $21 in premium. Assuming my numbers are correct, (from Google Finance), I know I would get called out, but still make 3% ROO with complete downside protection.
Your general approach and goals are very admirable and in line with those of conservative investors particularly in bearish or volatile market environments.
Now the trade that you describe sounds too good to be true. If we see a trade like this I would jump all over it after evaluating why it exists. I want an explanation.
In this case, my belief is that when you first accessed the options chain, Google finance had incorrect information that you based this trade on. It has since been corrected as shown in the screenshot below.
The share price is $44.29 which means we would lose $20.29 when the option is exercised. The “bid” price on the $24 call is $19.80, which means we would lose $49/contract + commissions with no possible way of making a profit unless we employed some extreme exit strategy maneuvers.
Most of these option chains are reliable but need to be verified before entering a trade. In this case, even if the stats were accurate I would research why the implied volatility was so high as to present such an unusual situation.
When things appear to be too good to be true they usually are.
Thanks for sharing this idea.
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Thank you as it seems the figures were off from what I got from the sight. But in general, back to my question:
If I always want to sell only deep in the money calls (DITM) since I’m only worried about downside protection. Is there any way to find high beta/high volatility strong stocks which will be good candidates for this strategy, and still potentially return 2-4% a month?
For our premium members, we provide beta stats on the “Running List” as shown in the screenshot below. General members can access beta stats on the IBD site which requires a membership fee. A free site for beta stats:
2- Type in ticker and “get quote”
3- Under “Company”, hit “Key Statistics”
4- Beta under “Trading Information”
I, personally, prefer the beta stats from the IBD site because it uses a 1-year time frame compared to Yahoo’s 5-year time frame. BCI uses the IBD stats in our reports.
These stats are constantly changing and can be accessed on a free site:
Set up a free account with a user name and password and you’re in.
My initial thoughts on accomplishing your goal:
1- Screen for high-quality stocks using fundamental and technical analysis as well as our common sense principles (like minimum trading volume)
2- Locate the high-beta stocks from this list as they are most likely to have high IV as well
Steps 1 and 2 are included in our Premium reports.
3- Feed information from the option chains into the multiple tab of the Ellman Calculator and make your selections based on the information gleaned from the white cells of the calculator.
For a free copy of the Basic Ellman Calculator click on the “free resources” tab on the black bar at the top of this page.
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Brad, Alan gave an excellent answer (of course). Here are two additional things to consider.
1) Look at delta. Delta is a pretty good approximation for the probability a given strike will still be in-the-money at expiration. By comparing strikes across various high-to-low beta stocks you might want to look at strikes at similar deltas. If by chance you use ThinkorSwim, use Prob ITM as it is a slightly better estimate than delta. Just remember, if your return is higher for one than another at the same delta/PITM, there is a reason…
2) By going DITM you’re trying to be conservative. Yet, by choosing stocks with high beta and high implied volatility, you’re being aggressive because these are the stocks that tend to move up and down a lot. So these two things seem like inconsistent strategies. Food for thought.
Hi Alan, I am back again with more questions to ask you.
The market has bounced back up quite quickly and seeing as I may do a MCU strategy some stocks, I first need to understand a few more things when applying this strategy.
– First if I am thinking of closing my positions for the ‘MCU’ near the end of the 2nd week (Wed/Thurs/Friday), then wouldn’t it be best for me to then wait until the next latest Premium report is out before thinking of buying another stock, or should it always be done simultaneously?(do I need to have already found another stock first?)
– And should any replacement 2nd stock for a MCU strategy always need to be from the bold-listed stocks? Thanks
Welcome back. My responses:
1- It is not essential that you wait for the next Premium Report. The goal of this MCU strategy is to generate more income with the new position (2nd income stream) than the cost to close which should be extremely small. Since theta (time value erosion) is logarithmic and picking up steam mid-contract, the earlier we enter the new position, the better. I will usually look to sell an ITM strike that generates 1-2% in the remaining 2+ weeks.
2- Yes, have a new stock in mind for the 2nd leg of this strategy.
3- No, all stocks in the “white cells” of the report are eligible, both bold and non-bold.
I bought XBI at $155.95 on 10/17 and STO $156 @7.5; then it sky-rocked all the way to $171 in less than 2 weeks. Refusing to see all the profit I can capture, I did the following. Not sure if I did it in the right way or not. Please comment at your convenience.
10/17/2014: Buy To Open @ $155.95 x 100
10/17/2014: XBI Nov 14 156.00 Call Sell To Open @ $7.50
10/23/2014 XBI Nov 14 156.00 Call Buy To Close @ x$12.40
10/23/2014 XBI Nov 14 166.00 Call Sell To Open @ $4.90
10/30/2014 XBI Nov 14 166.00 Call Buy To Close @ $10.90
10/30/2014 XBI Nov 14 171.00 Call Sell To Open @ $6.30
This has been an extremely successful trade for you, initially generating a 4.8% return in 1 week. Now as share price accelerated you were faced with a few decisions:
1- take no action…life is good
2- roll up (the path you did take)
3- wait for time value to approach zero and use the MCU exit strategy, the subject of this week’s article.
#2 works when share value continues to accelerate as it has in this case although it is down slightly as I write this response. Do we want to hang our hats on counting on this continued acceleration after a short-term substantial price rise?
I shy away from rolling up in the same month because of the conservative nature of my investment philosophy. If the time value component of the premium approaches zero, I opt for #3. If not, I opt for #1.
More aggressive investors may take the path you chose.
I am new to covered call writing and also your premiun member. I did the live trades for pass 2 month and very happy with the outcome.
I have a quick question, should I close the option with limit price? How to decide the best price? Or buy to close with market price?
When buying and selling options, it is always best to set limit orders. It will put cash in our pockets especially when leveraging the “Show or Fill” rule (see pages 225 – 227 of the Complete Encyclopedia…). If the spread is tight ($0.10 or less). go with the published bid price. If greater, set a price slightly below the mid-point (eg: $2 – $2.50 may be set @ $2.20).
As you all know, we have been staying very close to the ongoing StockScouter situation. Earlier today, we received an update email from Verus Analytics, the developer of the StockScouter indicator. They indicated that they are continuing to negotiate with other potential financial information websites and are exploring offering access to StockScouter via subscription. In addition, they sent us a listing of their StockScouter ratings as of the close on Friday, 10/31/14. As a result of this new information, I have updated the report. The impact of the new information is that 10 stocks that were listed as passing the screening process have now been moved to “Failed Current Week”.
In the email, Verus noted:
” Verus is not a business-to-consumer operation. Our clients are institutional in nature and thus, we do not have the staff to handle a lot of inbound requests and questions…We do not know if we’ll be able to provide these to you again, or on what cadence/timeframe…We have initiated discussions with potential partners to publish StockScouter scores…We are also evaluating distributing the scores via our website on a subscription basis. However, both of these paths take time to develop. We appreciate your patience as we look for a new home for StockScouter.”
Please look for the report dated 10/31/14 RevA.
Barry and The Blue Collar Investor Team
Alan, I would just like to round out this topic now before getting to something more important. My questions are:-
– If price has gone up above strike price a lot, and am thinking of doing a MCU, then is it alright for me to check the option prices like at a certain time near the end of each day, of the 1st 2 weeks of the contract? (not sure if I should need to have a check more than once a day either?)
– If I had completed a MCU on a stock, then is it alright to buy back the same stock again 2 weeks later(at expiry) to sell calls on it again the following month?
– Also when I have bought a new stock mid contract after applying the MCU strategy, then is the option value for these last 2 weeks to be at the 20% level or the 10% level for any option buyback? Thanks
1- This is an individual preference. I like to check my positions at least once a day (between 11AM and 3PM ET avoiding early and late market volatility). It only takes 2-3 minutes unless some kind of action is required.
2- If the stock meets our system criteria, it can be used the next month. My concern is that if the price has increased substantially in a short time frame, there may be some profit-taking and a share decline short-term is possible. If I opted to use this stock again in the following month I would probably write an ITM strike unless we were in a raging bull market. More likely, I would opt for another, less volatile stock.
3- The value of the option in the 2nd position should result in a net profit after factoring in the cost to close. If the cost to close was 0.5% and a new position generated 2%, that’s a net credit of 1.5% over and above the original option credit.
Another well written and thought provoking blog article by yourself has got me thinking about a couple points I would like your opinion on. If as in your example you buy a stock for $48 and sell a $50 option for $1.50 generating a 3.1% yield plus as stated the stock rises to $60 and you now have a potential additional $2 gain for a total potential yield of 7.3%.
Wouldn’t it be more prudent to allow this option to be exercised on expiration Friday and capture both the premium and the $2 share appreciation. If we do a buy back aren’t we returning all of the share appreciation and only capturing the time value? I can see doing this if this is a dividend paying stock you don’t want to lose possession of but if you do this mid-contract unwind you do still have your stock with it’s stepped up value which you have paid for.
You could try for a double if the numbers are right but if the stock price goes down you could be in for a disappointment. So what do you think of letting the option be exercised for a 7,3% yield and have a win-win situation for you and the option buyer. I would be ecstatic earning 7.3% every month. I ask your comment on this matter. Thank you.
I appreciate your question because it gives me the opportunity to highlight the beauty and advantages of one of my favorite exit strategies:
1- We can all agree that allowing assignment and thereby generating a 7.3% 1-month return is wonderful. However, by executing this exit strategy we have an opportunity to earn an even higher return…that’s what BCIers are all about.
2- We still capture share appreciation to the strike even when we use the MCU strategy as I will demonstrate below.
3- I want to be clear that when we implement this strategy the cash from the sale of Stock #1 is used to enter a new cc position with Stock #2, thereby generating a 2nd income stream in the same month with the same cash.
Now for the math:
1- Taking no action will most likely result in a 7.3% 1-month return
2- If we closed as time value approaches zero (let’s say $10.10 in your example…$10 intrinsic value and $0.10 of time value), we have an option debit of $10.10 and a share appreciation (from the $50 strike) of $10…we counted the share appreciation from $48 to $50. Net debit for closing is $10/contract or ($10/$5000) = .2% (a fraction of 1%). Let’s assume we can generate 2% in the new position. The exit strategy results would then be a net credit of: 2% – .2% = 1.8%
Total 1-month profit = 7.3% + 1.8% = 9.1%
Both approaches have great results but instituting this exit strategy under the appropriate conditions (time value approaching zero) will achieve the highest returns.
Alan & Alan, I think there is an additional huge issue with hanging on and letting it get exercised.
In your example, there is only 0.2% of max profit left to be made. What if some unexpected news event were to occur and the stock price drops? There is a lot more that can be lost than can be made.
At some point, you’d be hanging on to gain pennies when the risk to the downside would be huge in relative proportion. So to Alan Ward, the “prudent” choice would be to take the bulk of your max profit rather than putting/leaving it all at risk in order to gain pennies.
If you were using a different strategy that continued to have significant upside potential and your posture on the stock was still bullish, then you could argue to hang on. But for a strategy with a capped max profit, to hang is like “picking up pennies in front of a steamroller.”
Running list stocks in the news: AVGO:
Avago Technologies is a semiconductor company that produces radio frequency chips in smartphones made by Apple…not a bad company to be affiliated with! It also has an association with Samsung and other mobile device manufacturers.
According to Oppenheimer analysts, Apple represents 15% of Avago’s sales and impressive sales of iPhone 6 can only be an asset for this stock.
(SWKS is another “chip stock” on our “running list” benefitting from a surge in the semiconductor industry).
As a result of this positive news, analysts are raising guidance for AVGO for both earnings and sales as shown in the screenshot below.
Our Premium Watch List shows an industry rank of “A”, a beta of 1.56, a % dividend yield of 1.50, adequate open interest for near-the-money strikes and an ex-dividend date of 9-17-14.
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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 as well as the implied volatility of all eligible candidates.
For your convenience, here is the link to login to the premium site:
NOT A PREMIUM MEMBER? Check out this link:
Alan and the BCI team
Thanks Alan all great replies again.
For that previous 3rd question I was sort of meaning if the new 2nd stock then started declining – would there be a % guideline you had for any option buyback? (as within the 2 remaining weeks or so anything can happen)?
– When thinking about this strategy today something I remember you said somewhere is that the return on the 2nd stock should be substantially higher than the cost to close, otherwise you won’t think of applying a MCU at all.
If for instance initial return is 2%, cost to close is 0.50%, so unwind return = 1.50%. If you then get 1% on new stock, then total profit will be 2.50%, but is this enough as it is only 0.50% past the original 2% return?
So in that case would you have some minimum % that you need to actually see first or not?
I’ll ask other questions next week now. Thanks