Mid-Contract Unwind:
The major concern for covered call writers is the stock price dropping in value. The option premium collected is money in the bank. Most of our exit strategies are designed to mitigate these losses and turn losses into gains. However, as Blue Collar Investors we should also be prepared to act if the opposite scenario occurs.
From time to time, you will buy a stock, sell the call option and your equity will subsequently dart straight for the moon! That will leave your strike price deep in-the-money. One way of looking at this situation is that you made a significant profit, and now that cash is protected by the difference between the share value and strike price of the option, or the intrinsic value of the option premium (the amount it is in the money). If satisfied with this situation, you will just allow assignment and enter a new position the next contract cycle. There may be, however, an opportunity to generate even more cash in such a scenario, especially when there is still time left until expiration Friday.
When a strike moves deep in-the-money, the time value of that option premium declines and approaches zero. This means that the option premium consists predominantly of intrinsic value. The amount of cash it takes to buy back the option is greatly offset by the share appreciation we would realize by eliminating the option obligation (closing our short option position by buying the option back) and selling the stock. Always consider a mid-contract unwind exit strategy when the time value of the option premium approaches zero and there is enough time remaining in the current contract cycle to generate additional profit with another position.
Real-life example of a mid-contract unwind exit strategy:
There is nothing like a real-life example to clarify the utilization of the mid-contract unwind exit strategy. The charts and graphs below depict the primary stages that occurred when I utilized this strategy in a covered call position for the underlying security, Perrigo Company (PRGO). Initially, 300 shares of PRGO were purchased @ $51.10 on March 22nd, the start of the April contract cycle. At this time, three $50 call option contracts were sold for $2.10, yielding a profit of $100 per contract given that this premium consists of $1.00 of time value ($2.10-$1.10). A week into the contract cycle, PRGO had appreciated in value to $56.79, and the premium for the corresponding $50 call option had likewise appreciated to $6.90, as illustrated in the two figures below:
PRGO heads to the moon!
PRGO $50 call also heads to the moon
The drastic increase in PRGO share price and its corresponding option premium in such a short period of time prompts us to explore the potential to generate more profits by unwinding the initial position mid-contract and then selling the stock. In order to examine the viability of this cash-generating opportunity, we must first explore the current options chain for PRGO, below:
PRGO unwind options chain
"Unwind now" tab of Elite Calculator
Elite Calculator results
Perhaps, some may feel that we can generate the extra cash by rolling up, however, the following two reasons may render the decision to utilize this strategy an unwise one:
- The price of the stock may not be in a favorable position to generate a decent return
- Given the drastic share appreciation over a short period of time, the possibility exists that profit-takers (sellers) could cause the price to experience a drastic decline in value.
Instead of rolling up, let’s look for a new financial soldier to send out into the financial battlefield (this has all been decided prior to unwinding the original position). To do this, we look to our watch list, which contains 40-60 fundamentally sound equities, and (in this example), Bucyrus International, Inc. (BUCY) surfaces as a viable candidate. This stock was selected from our watch list which was established with the fundamental, technical and common sense principles addressed in my books and DVDs. We then put BUCY through our technical screens, which (in this example) it passed, as depicted below:
Technical analysis of replacement security
BUCY options chain
Conclusion:
When a stock appreciates in value over a short period of time, and there are still two weeks or more remaining in the cycle, unwinding your position may offer an opportunity to generate additional cash into your account. This is one of the strategies that sets us aside from all the others. The keys are that the time value of the option premium must be close to zero, and the new position must generate more cash than the amount of time value paid to close the original position.
All BCI Books now Available in both Nook and Kindle Format:
Nook (Barnes and Noble):
Cashing in on Covered Calls
http://tinyurl.com/cashinginonccs
Exit Strategies for Covered Call Writing
http://tinyurl.com/exitstrategiesforccw
Alan Ellman’s Encyclopedia for Covered Call Writing
http://tinyurl.com/encyclopediaforccw
Kindle (Amazon.com):
Cashing in on Covered Calls:
http://tinyurl.com/cashinginCCs
Exit Strategies for Covered Call Writing:
http://tinyurl.com/ccexitstrategies
Alan Ellman’s Encyclopedia for Covered Call Writing:
http://tinyurl.com/covered-call-encyclopedia
Market tone:
This week’s economic reports came in mostly positive as has been the trend for the past 4 months:
- New residential construction was down 4.1% in December but starts were up 24.9% over the past year.
- Building permits are up 7.8 from a year ago and has been uptrending for the past 8 months
- Existing home sales were up 5% in December finishing the year with 3 months of gains
- Industrial expansion rose 0.4% in December connfirming economic expansion
- CPI did not rise for the 3rd consecutive month allaying fears of inflation
- PPI also confirmed this trend by decreasing 0.1% in December, the 2nd decline in 3 months
For the week, the S&P 500 rose by 2.0% for a year-to-date return of 4.7%, including dividends
Technically, the market tone is bullish. We have an ascending, bullish trend (red arrows below) on significant volume (green arrow) with a very comfortable VIX reading @ 18.28 See the chart below):
Market tone as of 1-20-12
Alan,
I love this idea. I notice that in your second position you used an in the money strike price. Do you ever use out of the money options when using this strategy?
Thanks for another educational article.
Amy
In the BUCY example above where would you place your limit order? $4?
Thanks,
Ed
Premium Members,
The Weekly Report for 01-20-12 has been uploaded to the Premium Member website and is available for download.
Best,
Barry and The BCI Team
Premium members:
This week we have enhanced our Weekly Stock Screen and Watch List by adding the non-graphic aspects of the Market Tone and Summary taken from our weekly blog articles. This is located at the top of page 1 of the report. We made this addition based on a suggestion from one of our members. This way, the Weekly Stock Screen and Watch List along with the past week’s economic reports and market summary are all in one file.
Alan
Can I make a small suggestion name the current report 01-20-12_Weekly_Stock_Screen.pdf. I save them and the dashes make them easier to follow by file name.
Alan–
Although I usually sell covered calls, I have been playing with a techneque of finding stocks which seem to have a firm support level and then buying a call. This has worked extreamy well and I have developed a strategy to rapidly identify these stocks with firm support levels and which also meet other criteria. I’m using Strategy Desk from Ameritrade to develop the program.
To protect myself I tried placing a stop order on the option price. It didn’t work well, since the rapid change in option price dropped right through my stop and I was sold out at a much lower level than expected.
My basic questions — is it possible to place workable stop orders on options? Does the support concept to identify and buy options sound workable.
I of course win some lose some, but overall I’m doing very well . I think the techneque of dealing with stocks near an identifiable support level could also be used for finding low risk candidates for covered call selling.
Thanks for all your help. Your internet service and books have been a great help.
mike
Amy (#1),
Excellent question Amy, I’m glad you brought this up. Keeping in mind that I am a conservative investor and this strategy is utilized midway through a contract cycle, I do lean to ITM strikes. This will protect my profits as I have already maximized my initial position. Also, with only (about) 2 weeks remaining until expiration Friday, exit strategy executions are more challenging. Now, if we are in a strong bull market OTM strikes would be my choice. In normal market conditions, I lean to ITM strikes. More aggressive investors with a higher risk-tolerance may not subscribe to this approach.
Alan
“Unwind Now” Calculator tab:
I had several emails this morning asking where to locate the “unwind now” tab shown in this week’s article. I apologize for the confusion. This tab is NOT part of the Basic Ellman Calculator but is found in the “Elite” version of the Ellman Calculator. Premium members can access a FREE version of the Elite Calculator in the “resources/downloads” section of the premium site. Scroll down and look for “Elite Calculator”. There is also an extensive user guide I recommend you print out and read. It will explain all tabs and how to maximize results using this tool. General members can get a copy of the Elite Calculator in the Blue Collar store.
Since the Elite Calculator has so many tabs you will need to use the arrows on the lower left portion of the spreadsheet to access all tabs. In the screenshot below I have highlighted these arrows and where to locate this “unwind now” tab. To enlarge, click on the image and use the back arrow to return to this blog.
Alan
Ed (#2),
I have had the greatest success when “playing the bid-ask spread” by placing my limit order slightly below the mid-point, in this case @ $3.95. $5 per contract may not seem like much but these credits add up over time and are better off in our pockets than those of the market makers.
Alan
Frank (#5),
I’ll check to see the impact on the BCI archieving convention. If no impact, we’ll be able to accommodate you.
Best,
Barry
Your last report has MNST on your list for 24 weeks but I only see it going back a couple of weeks. What am I missing or misunderstanding. Thanks for your terrific work.
Jerry
Jerry,
MNST is the new symbol for HANS which has been on the stock list for several months. Good luck.
Barbara
Jerry (#11),
If you take a look at the entry for MNST on the “Running List”, you will note a notation in the comment space…”Was HANS”. Per Barbara’s comment (#12), Hanson Natural (HANS) changes its’ name to Monster Beverage Corp (MNST).
Best,
Barry
Alan,
I’ve been following KSU from your stock list. It just reported earnings which were up 75% and revenues up 30%. Looks like a blowout report. Is this a stock that would be good candidate for a covered call tomorrow or would you wait a few days?
Thanks a lot.
Tony
Barbara and Barry,
Thanks for your responses. I missed the comment on the report about the change in symbol.
Jerry
Jerry (#15).
Thank you for the kind words. Try to glance at the comment section. I tend to put info there from time to time.
Best,
Barry
Tony (#14),
A strong ER does not necessarily predict a positive market reaction. We saw Google get slammed recently and KSU is down 4% premarket. This is one of the reasons I avoid ERs in this conservative portion of my portfolio. I would wait for the price to settle, confirm that the stock still meets our system criteria and run the calculations to see if the results meet your goals.
Alan
Alan,
I can’t believe how KSU is getting killed today, down 7%. After reading the results last night I thought the opposite would happen. A lesson learned…no earning reports for me.
Thanks Alan.
Tony
Tony,
This is a good example as to how unpredictable these reports can be. This particular report actually represnted a 10% positive surprise. See the chart below:
Alan
FrankK (#5),
There is nothing preventing you from renaming the file anything you want. I name mine BCIyyyymmdd. The reason I use the date in reverse order is that it allows the files to sort by date order. I hate having all the Jan files showing up together so I have to sort the year, or, if you use the month’s letters, say APR, guess which month shows up first.
BCI20120110 will always sort before any other date in 2012 except the first nine days of January. Just right click on the name of the file and click “rename”. Type in whatever name you want.
Alan,
Do you ever write puts at lower strike prices/support levels on your covered call positions (creating covered short strangles) as a mid-contract strategy?
I’d be interested in hearing your perspective on the strategy and/or what you feel are the pros and cons.
Regards,
GDC
GDC,
I always admire and appreciate our members who think outside the box. Since most of our members are not familiar with covered short strangles, let me give a quick example:
Buy a stock for $24
Sell the $25 call for $1
Sell the $22.50 put for $1
In general, the advantage is that you are doubling you option income. The disadvantage is that you are doubling your risk. Other disadvantages could include:
1-monitoring three positions instead of two
2- brokerage requiring the injection of more cash into your account to secure the short put position
3- Possible margin call complications
Now to answer your question: I do not use this strategy but understand its value to sophisticated, risk-tolerant investors in neutral to bullish markets. It is NOT for most members of our BCI community.
In your hypothetical, you consider using a covered short strangle as a mid-contract strategy. Since the stock has appreciated substantially in a short period of time, one concern would be profit-taking. In this scenario, we have maximized our initial cc position and can unwind at little or no cost. My (conservative) preference would be to enter a new position, usually with an ITM strike and shoot for another 2% profit with downside protection. More aggressive investors may opt for an OTM strike or a more involved options strategy like the one you are highlighting.
There are many ways to make money with stocks and options. Covered short strangles are NOT for most members of our BCI community but may be appropriate for sophisticated traders looking to increase profits and able to tolerate the additional risk. Like covered call writing, any strategy we employ should be mastered before we expose our hard-earned money.
Alan
AAPL:
Congrats to our members who waited until after tonights ER before selling the call options.
Alan
Alan,
I’m one of your members who waited for the report before selling options on Apple. This was the result of last week’s article. Great timing! With 300 shares that should result in a profit of $10k and now I will sell the options. THANK YOU!
Sam
Stock splits:
In my books and DVDs I discuss how a stock split may be asset or a means of the Board of Directors to attract attention to a stagnant stock. Today we see an example of the latter where RES (NOT on our watch list) announced a 3-for-2 split and a 20% increase in its dividend. I took a look at the price chart to find that the price has remained stagnant over the past year and down 25% in the past 6 months.
Had the pattern been uptrending then the board may have been decreasing price/share to make it easier for retail investors to purchase shares in 100 lot increments.
The chart will oftentimes let you know why a split was declared.
Alan
Hello Alan,
I am trying to return, so to speak. Taking it slow, and I hope, sure. Must ask you:
Would you mind venturing an opinion on why there has been practically NO comments in most places on the use of stocks (with options of course) that represent the precious metals, and associated. Like Copper (FCX particularly).
I know the PMs have been down for quite some time now, but seem to be stirring.
Your highly respected views appreciated.
Thank You.
Don B.
Hi Don,
First let me say that you just made my day. You have a huge community of BCIers rooting for your continued recovery.
As always, you make a great point. The commodities are coming on. FCX has made many of us lots of cash several years ago and then went into hibernation. The reason it hasn’t yet re-surfacted on this site is that there are better candidates based on the BCI methodology. For example:
EPS Rating: 20%
Relative Strength Rating: 43%
Group (Industry) RS Rating: D minus
Now, all these rankings are improving and these equities definitely deserve watching. Technically, FCX is outstanding of late. I created a chart based on the BCI technical methodology below. Thanks so much for bringing this to our attention and once FCX meets our criteria you will find it back on our running list. Stay well.
Click on chart to enlarge and use the back arrow to return to this blog.
Alan
Don B (#26),
Your comment, as Alan said in the previous post , is quite timely. Depending on how you read and interpret the most recent announcements coming out of the Fed, it appears to me (my personal opinion only!!!), that the “QE” train is coming again. If you noticed, many of the commodities stocks were up recently. Today, GDX (Gold Miner ETF) was up big on big volume.
Just another view of the current situation.
Glad to see your comeback.
Best,
Barry
Premium members:
This week’s 6-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site.
PLEASE NOTE: Last week we added a new feature to our Weekly Stock Screen and Watch List (published on weekends). As a result of member suggestion we added the “Market Tone” section from our weekly blog article to the top of this weekly report, page 1.
For your convenience, here is the link to login to the premium site:
http://www.thebluecollarinvestor.com/member/login.php
Not a premium member? Check out this link:
http://www.thebluecollarinvestor.com/membership.shtml
Alan and the BCI team
UNP:
Last night Jim Cramer had the following take on this stock from our premium watch list:
“The “things are improving” theme continues with the railroads, said Cramer, where Union Pacific (UNP) trades at all-time highs as demand for cars, chemicals and materials heats up. Strength can be seen in the oil and gas sector, an industry that’s starved for workers. In the natural gas industry alone, up to 600,000 new jobs could be created as big trucks switch from diesel to natural gas”.
UNP has been on our “running list” for 5 weeks.
Alan
BIIB:
Another Cramer comment from his TV program last night:
For today’s installment of his “Medical Breakthrough Stocks” series, Cramer featured Biogen Idec (BIIB), a biotech company that he described as a “real winner.”
Cramer explained that Biogen’s main products are one of four current treatments for multiple sclerosis, all of which must be injected. The company currently enjoys 60% marketshare with its current treatment, but Cramer said the real blockbuster is Biogen’s latest treatment, currently in Phase III testing. He said this new treatment, called BG-12, is taken orally, and could add $1.5 billion to the company’s bottom line by 2015.
Biogen expects to file with the FDA before year’s end and could begin shipping BG-12 also by the end of 2012. While the company’s estimates are for $1.5 billion, Cramer said that industry expects suggest this new first-line treatment could balloon to $2 billion, with some calling for between $4 billion to $5 billion.
Biogen could make those number possible, said Cramer, as the company already markets its existing MS treatments to doctors, so promoting and selling BG-12 will be a breeze. Biogen also has two other drugs currently in Phase III testing, one for Lou Gehrig’s disease and the other for Hemophilia.
Cramer said with the potential for BG-12 so staggering and other big drugs in the pipeline, the time to invest is Biogen Idec is now.
The BCI team will NEVER put a stock on our watch list because of the say-so of any one expert, all stocks must pass of stated BCI screens. However, we will (from time to time) publish the fact that these experts have identified stocks that are already on our “running list”.
Alan
PLL:
Another stock from our premium watch list recently published a stellar 1st quarter earnings report with earnings up 19% and sales up 17%. This represented the 6th positive earnings surprise in 7 quarters. PLL also had its dividend raised by 20% to a current yield of 1.4%. Our “running list” shows an industry segment rank of “A” and a beta of 1.29.
Alan
For those of you who have noticed the “resurrection” of Netflix: There seems to be a lot of discussion about how much the recent increase was the short sellers covering their shorts.
I have discussed this before. There are often tow buyers pushing a stock up. The one who buys and hopes the stock goes up, and the one who sold it short, and is just getting out to avoid losing money as it rises. There are some companies where the short interest is 15%, 20% or more, of the outstanding shares. It is often helpful to know how much the short interest is. It could indicate that a rise in the stock price will get more people to jump on the bandwagon than you might otherwise have.
Running List Stocks in the News: DCI:
DCI has been on our running list for 7 weeks. Today it announced a 2-for-1 stock split payable on March 23rd. This will impact the April contracts since shares will double and price halved after the February expiration. The company also announced a 7% increase in the annual dividend to $0.16/share (every little bit helps!). Both serve as assets for this equity. For a review of stock splits as they impact our covered call positions see Chapter 12, pages 323-26 in “Encyclopedia….” or chapter 17 in “Cashing in on Covered Calls”. Our premium watch list shows an industry segment rank of “A” and a beta of 1.28.
Alan
Alan – I’m new and a little confused about the example in this article. It seems that whether you leave the call to be exercised or buy it back, you end up netting about $300 by end of contract and you lose your shares in the deal. I don’t see how this is attractive even if one focuses on the short term of only three weeks. If one had merely kept the shares and sold without writing the call, you would have made over $5 per share.
Mike,
There are two issues here:
1- I could have made $500 instead of $300. Yes that is true if one could have predicted the huge price increase in such a short period of time. Before investing we must define the strategy that we are focusing in on (like a laser) and then maximize those profits. We can’t decide on a strategy and then say that if we used a different strategy the results would have been different. If we simply purchased a call option we would have blown away the results of share ownership.
This is an unusal situation that we must be prepared to act upon to maximize our investment. Our original position returned 2% in 1-month WITH over 2% protection of that profit. 2% in 1-MONTH…how much is your bank paying for a 1 YEAR CD? Capping the upside to the strike price is one of the understood ramifications of cc writing.
2- I would have made the same money if I didn’t buy back the option. Yes, on the original investment because the result was maximized because of the huge share appreciation. By unwinding early at virtually no cost (time value) to us, we can then take the cash and use it to set up a second income flow in the same month.
Let me know if this now makes sense to you.
Alan
Oh I quite agree that there’s no divining of the stock surge that “might be.”
And I do get that we shouldn’t compare our strategy to what we could have gotten in another strategy.
But you say this was an unusual situation. I’m confused on that. Because as I see it, you know right up front what you’re going to get out of the deal. Doesn’t matter what the stock does after sale of the option.
If he lets it expire you get the $630. If he exercises, you’re only getting $50 per share and the premium, which translates to $300.
And the move to buy back the position actually nets you less than leaving the call to be exercised. I don’t see these as attractive unless you sell a lot of contracts which ties up a lot of shares.
So for me, I wouldn’t have sold an in the money call that put me a dollar per share behind my break even at the sale. It would have been different had I owned the shares for a month having bought them at say 48, then sold a 50 when the market was 51.10.
Am I evaluating this right?
Mike
Mike,
There are many ways to make money with stocks and options. The way I handled these trades may differ from the approach others would have taken. Let me take a step back and explain what I did in each step of these trades and why:
1- I purchased PRGO @ $51.10 and sold the $50 call for $2.10. This generated a 2%, 1-month return with 2% protection of that profit. I sell ITM strikes when I have concern regarding the overall market conditions or stock technicals. I don’t always sell ITM strikes. In a bull market with great technicals I favor OTM strikes. Every situation is evaluated on its own merit and in my optinion this approach can add huge financial gains to your portfolio in the long run…one size doesn’t fit all.
2- I did NOT know going in that I was going to execute this exit strategy but I was prepared for it and others. As it turned out when PRGO went above $56, the time value of the option approached zero. This meant that I could exit my original positions with maximum profit (2%) at virtually no cost (time value) to me. By doing so, I was able to use the same cash to establish a second income stream in the same contract month. This generated an ADDITIONAL 2.2% profit (with 3.7% downside protection of that profit). Had I not executed this exit strategy my 1-month return would have remained @ 2% instead of a final 1-month profit of 4.2%.
I feel it’s more important that you understand what I did and why rather than necessarily jump onboard and say you would have done the same thing. More aggressive investors may have sold an OTM strike to begin with. I hope I’ve added some clarity to these trades.
Alan
Thanks Alan. Need some time to digest the above. Reading your “Cashing in . .”
Mike
Alan,
Hi. Thank you for the example–it is very educational to me. I followed the math until I got to the sentence “This 2.2% figure translates to a $115 per contract “bonus” for instituting a mid-contract position unwind exit strategy.” Would you please explain how you derived the $115 per contract bonus–I cannot determine how you calculated $115.
Thank you very much,
Rich
Rich,
The premium generated from my second position was $3.90. Of that $2.48 was intrinsic value leaving $1.41 of time value (profit). After deducting the cost to close position1 and commissions, my second cash flow netted $115 per contract.
Alan