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Converting a Covered Call Trade to a Collar Trade: An Analysis Using ALXN

When we sell and in-the-money or at-the-money strike and share price moves up substantially, we have an unrealized maximum return. On 4/5/2019, Doug wrote to me about such a situation he was in with Alexion Pharmaceuticals, Inc. (NASDAQ: ALXN). He was considering buying a protective put to protect part of the unrealized profit and thought that this would be a better approach than closing both legs of the covered call trade. If a protective put is added to a covered call trade, it is then considered a collar trade where the call limits share value appreciation and the put limits share loss to the downside.

Doug’s trades

3/15/2019: Buy 100 x ALXN at $135.18

3/15/2019: Sell-to-open 1 x $135.00 4/18/2019 call at $5.11

4/4/2019: ALXN trading at $140.42

4/4/2019: The cost-to-close the $135.00 short call is $6.60

4/4/2019: The cost to buy a $135.00 protective put is $1.05

Doug’s initial time value return (ROO) using the multiple tab of The Ellman Calculator

covered call writing calculations

ALXN: Initial Calculations

The yellow cell shows an initial 1-month time value return of 3.7%. Since this is a near-the-money strike, there is no upside potential and negligible (0.1%) downside protection.

Option chain showing the cost of a protective put

protective puts

ALXN: Put Option Chain

The brown-highlighted row shows an ask price of $1.05 for the $135.00 protective put. Calculations for collar trades will be facilitated by using the BCI Collar Calculator.

Calculations and the decision-making process

Protective put: $1.05 presents about 0.8% of our initial investment, lowering our returns from 3.7%% to 2.9%, not bad.

Option chain showing the cost-to-close the $135.00 short call

reading an option chain

ALXN: Cost-To-Close Option Chain

The brown cell shows an ask price of $6.60. With the stock trading at $140.42, the intrinsic value of this premium is $5.42, leaving the time-value cost-to-close at $1.18 ($6.60 – $5.42). The time-value cost-to-close is $13.00 per contract greater than the cost of the protective put. Since we are currently mid-contract with 2 weeks remaining until expiration, closing the entire position (known as the mid-contract unwind exit strategy in the BCI methodology) at the cost of $13.00 per contract makes sense since we are in a position to generate more than $13.00 per contract by using this now freed up capital to enter a new position, with a new underlying, and generate a second income stream in the same contract month with the same cash investment.

Discussion

When a strike moves deep in-the-money, purchasing a protective put will definitely lock in a percentage of the current unrealized profit. As the time value approaches zero, the mid-contract unwind exit strategy may be an even better choice. There is also a third possible choice and that to take no action and continue to monitor our position. In this case, I would favor the mid-contract unwind exit strategy.

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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.

24 Responses to “Converting a Covered Call Trade to a Collar Trade: An Analysis Using ALXN”

  1. Dietmar September 21, 2019 3:15 am #

    Good morning Alan,

    I have a question regarding WEN. It looks like the stock is forming a bottom and starts to climb back up. The sudden drop of 10+% seem to have been an over reaction. Now, being slightly in the money with my covered call and having another 28 days until contract expiration, I wonder if it is better to BTC and roll up now or wait some more time. If I understand correctly, the higher the stock climbs, the more expensive the BTC will be. Should it hit resistance and drop back it would probably be the perfect time for BTC, but who knows which way it will go.

    Thanks for your thoughts.
    Dietmar

    • Alan Ellman September 22, 2019 7:01 am #

      Dietmar,

      When we sold a strike that is currently in-the-money, our maximum return has been achieved (although “unrealized” at this point in time).

      If share price moves higher, the cost-to-close does increase but mostly in the form of intrinsic-value while the time-value cost-to-close actually decreases.

      Given that our stated goal is cash generation from option-selling, we must decide how much of the initial time-value profit we are willing to sacrifice in the hopes of achieving a second income stream in the same contract month.

      In the BCI methodology, we seek to achieve at least an additional 1% of time-value profit over and above the time-value cost-to-close. Use the “Unwind Now” tab of the Elite version of the Ellman Calculator (free to premium members and available in the BCI store to others) to do the math.

      Let’s say the time-value cost-to-close is 0.,5% for the now deep in-the-money strike (intrinsic-value will be high but compensated for by the additional share value our shares are worth by removing the strike obligation). We then ask ourselves if the can generate at least 1% more than that time-value cost-to-close in a new position. Check the “mid-contract unwind” exit strategy in my books and DVDs.

      I don’t like rolling up in the same contract month for a stock that has been accelerating substantially. I will review rolling the option considerations as expiration approaches.

      Alan

  2. Sagar September 21, 2019 5:25 am #

    Hi Alan,

    I entered cash-secured put on a stock in the Indian exchange and the contract is nearing expiry. I am glad that the stock I want to own has dropped in price, but it dropped just more than what I wished. It has dropped more than 3% below the strike price and I incur a loss in the put option.

    The fundamental reason for the drop in price is the appreciation of INR against USD. The company gets a majority of its revenue from foreign countries.

    I have no problem owning the stock at the current price, but the technicals don’t look great for the near future to convert my position into a covered call. Please see the screenshot for the technicals.

    I also sell strangles in the Indian Index NIFTY along with selling covered calls. An advantage of owning the stock is that I can pledge the shares of the stock to get some margin to sell options.

    I have thought of two alternatives:

    1. Buyback the put option, buy the stock and not write a call option (because the company is announcing its quarterly results next month). Pledge that stock for margin and earn some return on that.

    2. Do nothing, just take a loss in the put option. Wait until the results are announced and reassess the performance, maybe writing another cash-secured put or selling a covered call.

    What are your thoughts on this? Please let me know if you need the exact numbers or any other information.

    Any help is appreciated.

    Thank you,
    Sagar

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

    • Alan Ellman September 23, 2019 7:53 am #

      Sagar,

      What we know about the stock:

      1.It dropped more in price than anticipated.

      2. Chart technicals are all bearish and confirming this bearish sentiment.

      What we know about the put position:

      1. Stock price > 3% below the strike.

      2. In our BCI methodology, the guideline is to buy back the short put and use the cash to enter a new put trade with a different underlying. See pages 137 – 139 of my book, “Selling Cash-Secured Puts” Assessment of this underlying can be re-evaluated after the earnings report. In the interim, we want to stop the bleeding.

      Have you looked into trading on US exchanges where their may be many more opportunities?

      Alan

  3. Barry B September 21, 2019 10:42 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 09/20/19.

    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

    Best,

    Barry and The Blue Collar Investor Team

    [email protected]

  4. Fran September 22, 2019 4:12 am #

    Alan,

    I became a premium member 3 months ago and love all the information in your reports. Can you explain the significance of the VIX which appears on page 1 of the stock report and how it effects our trading decisions.

    Thanks a lot.

    Fran

    • Alan Ellman September 23, 2019 7:06 am #

      Fran,

      When the market moves down, there is usually an increase in volatility which is what the VIX (CBOE Volatility Index) measures. The opposite also holds true. Therefore, the VIX is usually inversely related to market performance so it benefits us, as conservative investors, to take bullish positions when the VIX is low and descending and more defensive positions with a rising VIX.

      As with all our decision-making parameters, the VIX is factored in as one of many criteria that provides us with a mosaic that guides us to our investment decisions.

      Alan

  5. Tom Madine September 22, 2019 10:26 am #

    Excellent info, as always.

    When I encounter this scenario (short call goes deep ITM), and I have an ongoing bullish outlook on the underlying, I consider closing the short call and using a stop (or alert) to protect the profit on the long.

  6. Doug September 22, 2019 11:58 am #

    Alan,

    I have been doing some portfolio overwriting on the side with some etfs. Would generally like to keep the same portfolio of etfs. However a few got assigned this past Friday. Example:

    IYR

    -Purchased 100 shares in May.
    – as of 9/19/19 breakeven was 88.68 (after writing calls monthly since May) and most recent strike On my short call was 92
    -assigned 9/20/19 for 92 with IYR at 93.53

    Trying to determine:

    1. Let it go and move on (take profit of 3.88 and select new ETF for an October covered call)

    2. Repurchase shares of IYR at market On Monday and write call for highest October strike 92 or above that results in breakeven under 88.68 – basically roll forward for credit as if assignment didn’t occur

    3. Start writing cash secured naked puts in IYR starting at strike of 92 Being happy to buy it back at 92 (as if the recent assignment didn’t occur).

    Thanks so much.
    Doug

    • Alan Ellman September 23, 2019 7:32 am #

      Doug,

      Let’s assume you paid $87.00 for the ETF in May. Your 4-month return is 3.8%, 11% annualized. Not bad, especially when compared to what we can earn with a fixed-income instrument.

      With the most recent strike in-the-money on the 19th, we look to see if the security still meets our system criteria to be retained in our portfolio. If yes, we then evaluate the calculations for rolling the call (“What Now” tab of the Ellman Calculator). If the calculations meet our initial time-value return goals, it’s time to roll. This will replace allowing assignment and re-purchasing the shares on Monday. If no, we allow assignment.

      If we still like the stock but want to take a more defensive approach to our trade we can roll out and gain the intrinsic-value protection of the new strike or roll out-and-up to a still in-the-money strike (say $93.00 with IYR)… probably would lean to rolling-out.

      Our strategy must be defined before we enter our first position. Selling a cash-secured put that will allow us to buy at $92.00 is precisely where we were at on the 19th.

      Alan

  7. George September 23, 2019 2:39 pm #

    Alan,

    Please provide me with the names of brokers that I can trade Mini Options.

    Thank you very much,
    George

    • Alan Ellman September 23, 2019 5:57 pm #

      George,

      Mini options have been one of the few failed products established by the option exchanges in recent memory. I had a suspicion they would fail when brokerages didn’t reduce trading commissions thereby making the percentage of trading cost tenfold that of traditional options.

      That said, I know of no minis on stocks or ETFs (there could be, I just don’t know of any that still exist). There are some minis on indexes (XSP, MNX)… could be more.

      I would expect that most big-ticket brokerages will facilitate trading minis. I would proceed with caution.

      Alan

  8. Dietmar September 24, 2019 3:55 am #

    Alan,

    today a friend of mine tought me an interesting lesson. According to the new PRIP KID Packaged Retail Investment and Insurance-Based Products (PRIIPs) regulation by the European Committee Europeans are not allowed to invest in US ETFs such as the S&P ETFs, GLD, GDX, GDXJ, SLV, etc.
    Presumably for the retail investor’s safety. Wow, how nice of them. They weren’t able to prevent the stealing of funds from Zyprus bank accounts, the Greek disaster or the latest Italian bank frauds. I wonder what the real reason is. Maybe it’s harder to steal from a US based ETF?

    I thought this might of interest to you.

    Kind Regards
    Dietmar

    • Alan Ellman September 24, 2019 8:10 am #

      Dietmar,

      This is interesting. The gold and silver ETFs have implied volatility nearly triple that of the S&P 500 so a case can be made that they may be too risky for beginner traders. Banning S&P ETFs is another story unless they are leveraged ETFs.

      Thanks for sharing.

      Alan

    • Sunny September 24, 2019 10:00 am #

      Yes, I’m from EU and we can’t purchase any US based ETF’s (including SPY, QQQ, GLD, ‘spiders’ and all others) anymore, because they are not compliant with new EU regulations. But as I know EU residents can still trade US ETF options on their accounts. So we are not allowed to trade ETF covered calls, but we can trade ETF PMCC or major US indexes.

      I have account on TradeStation and they UK branch somehow overcomes this restriction. Even if I’m resident of EU I can still trade all US ETF’s. But for those trading through InteractiveBrokers, for example, they are not allowed to do this anymore. My local bank removed all US ETF’s from they trading platform last year too.

      Sunny

      • Terry September 25, 2019 10:49 am #

        I don’t understand the logic in the EU not allowing investments in US based ETF’s.

        Terry

        • Sunny September 25, 2019 4:24 pm #

          Terry,

          It’s not about EU not allowing to trade US ETF’s. As I know US based ETF’s didn’t provided required documents to be compliant with new EU regulations. I have no idea what are the reasons behind this.

          Sunny

  9. Alan Ellman September 24, 2019 5:44 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 as well as the implied volatility of all eligible candidates.

    New members check out the video user guide located above the recent reports.

    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

  10. Alexei September 25, 2019 1:45 am #

    Alan,

    I’ve listened and viewed many of your youtube videos on covered call. I’m about to start the journey and BCI membership would be a great starting point for me as it will simplify and I hope will educate on how to select stocks for covered call writing.

    I’ve reviewed Covered call writing series on youtube and you are talking about them be only a review of more detailed information. What product(s) contains complete information? Where should I look for more information?

    And finally, I have 50K ira account. Your advice is to split it into 5 or more stocks in different sectors. With these kinds of fundings, it is a little too thin as most of the Dow companies(stable with low volatility) are trading above 100 and I won’t make even one contract.

    Thanks for your great videos of the subject and for your help.
    Alexei

  11. Nick September 25, 2019 3:12 am #

    Alan,

    Quick question on options for the sector SPDRs. Every week I look at the top three and while they might out perform the SP500 and be a good stock investment, I haven’t seen options that were worthwhile. Below is spreadsheet for the three top performances this week (XLU, XLRE, and XLP) for both ITM/OTM strikes just above and below current stock prices.

    My analysis shows

    – Max 1.0% return for ITM strikes with some downside protection. That isn’t so interesting.

    – 1.0% ROO with 0.3% upside for OTM strikes. Overall return isn’t worth it.

    – 0.1-0.5% ROO with 1-2% upsides for OTM. In this case the ROO of the option isn’t worth the limited upside

    Am I missing something or is it frequently the case that ETFs aren’t that great an option play and one has to pick and choose?

    Thanks,

    Nick

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

    • Alan Ellman September 25, 2019 6:14 am #

      Nick,

      There is no correct answer to your question that applies to every investor. You are spot on in that ETFs generally offer lower returns than individual stocks (there are exceptions). This is because they have lower implied volatility and therefore lower premiums.

      I use these in my mother’s account because there is less risk and premiums rich enough to make a difference in her life.

      In the 3 examples you present, if we took the highest ROO, here are the 23-day and annualized returns:

      XLRE: 1% (16%)

      XLU .6% (10%)

      XLP: 1% (16%)

      For some, this will do. For others, ETFs may not meet their goals. This is why we provide 3 reports to our members: stock, ETF, blue-chip).

      Alan

  12. Ken September 25, 2019 4:04 am #

    Hi Alan,

    Last month’s covered calls were profitable 😊

    I have one more question that came to me during expiration Friday last week:

    For ITM expiring calls, why is it recommended in the BCI system to roll out or roll up? My broker (interactive brokers) doesn’t charge assignment fees, and the commissions for buying/selling is pretty low also (usually $1 per trade). Since the commissions are immaterial, isn’t it better to have the stocks get called away, and just “reset” on Monday – re-assess the stock list and do the entire cycle again, this time we get the chance to rebalance the portfolio, and even find better stock candidates along the way? I don’t understand the part that rolling out/up increases the profits – where is the advantage? Aren’t the bottom line numbers the same if I buy the same stock on Monday and sell fresh calls again (and I can adjust the position size also)?

    Thank you very much!
    Ken

    • Alan Ellman September 25, 2019 6:34 am #

      Ken,

      When we consider rolling an option, we first make sure that this is a security that still meets our system criteria. Assuming it is a stock we want to retain in our portfolio, we run the rolling calculations using the “What Now” tab of the Ellman Calculator.. Let’s also assume that these stats meet our initial time-value return goal. This applies to rolling out or out-and-up.

      There are 2 advantages of rolling versus allowing assignment and re-purchasing the shares on Monday:

      1. You have already identified the commission benefit which, when broker fees are extremely low, makes the advantage muted but still present. When we roll, there are 2 commissions. If we allow assignment then re-establish a new covered call position on Monday, we incur 3 commissions.

      2. More importantly, prior to expiration, we know our cost-basis (the current strike + the time-value cost-to-close) for the new contracts. That is what our shares are worth at that point in time. When we buy-to-close as 4 PM ET on expiration Friday approaches, we pay intrinsic value + a few pennies. We know our cost-basis.

      If we allow assignment, we don’t know our cost-basis until the stock price opens on Monday. If share price moves up, we will pay a higher price than the rolling cost-basis. Let’s say we sold the $50 call and the stock was trading at $52 as 4 PM approached. Let’s say the cost-to-close was $2.10 making our cost-basis $52.10 (before selling the next-month option). Now, let’s say the stock price opens at $54 on Monday…

      Of course, the stock price may open at a lower price but we just don’t know. So, if the “deal” is there, take it. Worst case scenario, we have a stock we like with calculations that meet our goal.

      Great question.

      Alan

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