Mastering option trading basics includes incorporating exit strategies into our portfolio trades. These opportunities present themselves both when a stock prices declines and accelerates. Recently, a premium member presented me with a hypothetical trade involving FSLR that I felt would be of interest to the entire BCI community. Let me premise my remarks by saying that FSLR is NOT currently on our premium watch list but has been in the past. Here are the particulars and then we will discuss:

• March 18th: Buy FSLR @ $27.25 and sell the April $28 call for a 3.5% initial, 1-month profit
• April 9th: Price of FSLR gaps up to $39 and the $28 call option to $11.10
• The additional share appreciation brings the trade profit to > 6% and is maxed out no matter how high the price goes
• There is an upcoming earnings report prior to the May expiration

Let’s take a look at the price chart of the stock showing the gap up:

 

FSLR price gaps up

 

Next, let’s look at the price chart of the April $28 call option demonstrating the corresponding gap up:

 

The question posed to me was which of the following actions should we consider?

• Buy back the $28 call and roll up to a higher strike to benefit from additional share appreciation
• Since the earnings report negates the choice of rolling out, just allow assignment after expiration Friday
• Another choice?

Let’s review these choices:

Rolling up in the same month

I generally don’t take this approach because a stock that has gapped up may decline in price due to profit-taking (which it did as of this writing). In addition, we will be incurring an option net debit and thereby depending on further share appreciation to make this approach profitable. Let’s reject rolling up in the same month.

Allow assignment after expiration Friday

An astute observation by this member to avoid the next month earnings report. This is a viable choice if there is none better. A > 6%, 1-month return with protection all the way down to $28 is not a bad deal!

Another choice (notice how I’m avoiding the word “option”)

You know how I love to squeeze every ounce of profit from our trades and we may be able to do so here. Because of our option obligation, our shares are worth $28, not $39. If we close our short options position and buy back the $28 call for $11.10, our shares are now worth market value or $39. Let’s do the math:

$11.10 debit (buying back the option) + $11 credit (share appreciation from $28 to $39) = net debit of $0.10 = $10 per contract.

Since we no longer have an option obligation we can sell our shares for $3900 per contract and put this cash right to work. If we can institute a NEW covered call position in the last 9 trading days of the April cycle which generates more than $10 or four tenths of 1% then we have successfully instituted an exit strategy and created a second income stream in the SAME month with the SAME cash. I call this the mid-contract unwind exit strategy.

 

Link to sign up for my April 2oth seminar in Atlanta:

http://www.meetup.com/Atlanta-Option-Investors-Club/events/113533742/

 

Market tone:

This past week’s economic reports leaned to the negative but the stock market remained strong. The Fed policy makers expressed concern over the impact the sequester may have on our recovery:

• The Producer Price Index (PPI- a measure of the average change over time in the selling prices of a fixed basket of goods by stage of production, industry, and commodity. It is
  considered a leading indicator for consumer inflation. The “core” PPI excludes food and energy prices—which account for roughly one-quarter of the broad PPI and tend to fluctuate widely—providing a truer reflection of inflationary trends) dropped 0.6% in March (-0.1% expected), the largest 1-month drop since May, 2012. A big component of this decline was due to the 6.8% drop in gasoline prices
• Initial jobless claims for the week ending April 6th came in at 346,000, less than the 365,000 projected
• According to the Labor Department retail sales (a report of the dollar value of sales of a broad range of goods, from cars and gasoline to furniture, food services, and clothing. Retail sales are a major indicator of consumer spending trends, accounting for a substantial portion of total consumer spending and aggregate economic activity) in March fell by 0.4% after rising 1% in February
• The minutes from the March 19-21 FOMC meeting revealed that some policy-makers were concerned over the impact the sequester might have on current monetary policy of quantitative easing where the Fed is buying $85 billion a month in US Treasuries and mortgage-backed securities. The concern relates to possible increases in interest rates and inflation
• Business inventories increased by 0.1% in February, less than the 0.4% anticipated

For the week, the S&P 500 rose by 2.3%, for a year-to-date return of 12%, including dividends.

Summary:

IBD: Confirmed uptrend

BCI: Moderately bullish but favoring in-the-money strikes until the impact of the sequester is quantified or resolved.

The entire BCI team thanks you for your amazing support.

 

My best to all,

Alan ([email protected])

www.thebluecollarinvestor.com