With expiration Friday and earnings season fast approaching our common sense principles (see chapter 8 of my latest book) become even more important. Never sell a covered call option with an upcoming earnings report is a critical BCI rule. But what if you own a stock and love it! Hopefully, your admiration for the stock is predicated upon non-emotional reasons and sound fundamental and technical principles, in addition to common sense. In most cases, we would sell this equity prior to the report and then re-purchase the stock after earnings are announced, assuming, of course, that the security still meets the BCI system criteria. However, what if you really believe in this company and feel that the share price most likely will continue to appreciate in value? In such a situation, one can own the stock through earnings and then sell an option after earnings are reported and the price settles down. In other words, you can capture the best of both worlds: the share appreciation from a positive earnings report surprise (what we are anticipating) plus the cash generated from the sale of the option. Before I continue with a real-life example, let me again re-state that this is not part of the BCI System. However, it is something I have done in the past. Any time you own a stock through an earnings report there is the likelihood of volatility and the direction can be positive or negative. We refrain from selling the call because we would limit the upside of a positive surprise (by the option strike price) without downside protection, notwithstanding the option premium which could pale in comparison to the potential price decline in the underlying equity if there was a negative surprise.
That being said, there are limited situations wherein I do retain ownership of the stock through earnings, and thereafter sell the call option when the price of the underlying equity settles, as noted. Let’s look a t a real-life example where I used this strategy with positive results. The following is a brief outline of the six key aspects that existed and affected my decision to retain ownership of RVBD through earnings:
- I bought RVBD and sold the July call
- I closed the short option position when the stock and option price declined, in preparation to execute an exit strategy (discussed more fully in Chapter 10 of Encyclopedia for Covered Call Writing).
- I re-sold the same option in the same contract period when RVBD increased in price (“hitting a double” exit strategy)
- The option expired worthless and the stock was retained prior to the earnings announcement
- The earnings report positively surprised and the share price accelerated
- An option was sold on the next higher strike price after the earnings report was published
For purposes of clarity, I have constructed a line chart depicting the aforementioned six key aspects, which are numbered accordingly on the graph, inclusive of a red arrow indicating the execution of each trade that was effected. Please review this chart and the explanation that follows (trading commissions not included but should be non-events):
The following numbers reference the numbers shown in the chart:
1- Initial covered call trade:
- Buy 500 x RVBD @ $29.80 (cost basis = $14,900)
- Sell 5 x July $30 calls @ $1.53 (initial profit = $765)
- Initial return = $765/$14,900 = 5.1%
2- Close short call position (buy-to-close):
- B-T-C 5 x July $30 @ $0.20
- Creates a debit of $100
3- Re-sell the same call in the same contract month:
- S-T-O 5 x July $30 @ $0.65
- Creates a credit of $325
- Exit strategy (2 and 3, I call “hitting a double”) credit = $225 ($325 – $100)
- Total profit to date = $765 + $225 = $990
4- Stock price closes below the $30 strike on expiration Friday:
- Option expires worthless allowing the stock to be retained
- one-month profit = 6.4% ($990/$14,900)
5- Earnings report is announced:
- On July 22nd the earnings report is made public
- The market reacts favorably to a positive earnings surprise (I’m a genius….this time!)
6- Sell the next month call option at a higher strike price:
- The stock appreciates to near $35 per share and the slightly O-T-M $35 call is sold for $1.35
- S-T-O 5 x August $35 calls @ $1.35 = $675
- I compute my returns based on share value at that point in time: $675/$17,400 = 3.9%
- At the time this chapter was written, the price of RVBD = $36.80, making the stock worth $35 per share (to me) due to the option obligation
For the fun of it:
Although this contract cycle was far from over as this article was being formatted, let’s compute our returns to date starting with the first covered call sale:
$765- initial option profit for the July contracts
$675- initial option profit for the August contracts
$2600- share appreciation from $29.80 to $35 for 500 shares
Total profit = $4265
Initial investment = $14,900
2-month return = 28.6% ($4265/$14,900)…I’m not even going to annualize that!
The foregoing example was provided primarily in response to the myriad of inquiries I have received in connection with retaining a favored equity through an earnings report. Although this strategy is not part of the BCI system for selling covered call options, I do occasionally utilize same, (especially in bull markets) as detailed above. Bear in mind, however, that the positive results yielded in above-referenced example are not guaranteed. Had earnings disappointed, we’d be looking for a box of Kleenex! The main point here is to be prepared; holding a stock through an earnings report is for investors with a higher risk tolerance and works best in bull market environments.
This week’s reports pointed to a strengthening of our economy:
- Consumer borrowing rose about 10% in November, the largest increase since October, 2001
- Retail sales rose by 0.1% in December, the slowest increase since May but an increase nonetheless
- Business inventories (a measure of change in GDP) rose 0.3% in November
- The trade deficit widened but reflected stronger consumer demand and business restocking
- The Beige book Report showed strengthening job growth and production in ALL regions from late November to the end of December
For the week, the S&P 500 rose by 0.9% for a year-to-date return of 2.6%, including dividends.
IBD: Confirmed uptrend.
BCI: Cautiously bullish beginning to utilize a small percentage of OTM strikes.
Wishing you the best in investing,
Alan ([email protected])