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:
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:
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:
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.
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Cashing in on Covered Calls
Exit Strategies for Covered Call Writing
Alan Ellman’s Encyclopedia for Covered Call Writing
Cashing in on Covered Calls:
Exit Strategies for Covered Call Writing:
Alan Ellman’s Encyclopedia for Covered Call Writing:
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):