Covered Call Writing Quiz: Evaluating a Series of Trades

Managing our covered call positions is essential to our overall option-trading success. In July 2019, KA Lau shared with me a series of questions he developed based on a real-life trade. I felt that these were excellent educational questions and will now share them with the BCI community. I added 4 more questions for a total of seven.

Take a Covered Call Writing Quiz

Hypothetical trades based on a real-life scenario

• Volatile stock XYZ trades within a range of \$15.00 to \$35.00 historically
• The stock is initially purchased at \$20.00 per-share on July 1st
• The next day, the stock price moves to \$25.00 per-share and the August \$30.00 call was sold for \$1.00
• The following week, the stock price rallies to \$35.00 per-share and the \$30.00 call is rolled-down (cost-to-close is \$6.00) to the December \$25.00 strike (\$13.00 premium)

7 Questions

1- Assuming the December contracts expire in-the-money and shares are sold, what is the overall profit upon assignment?

• Stock profit (\$25.00 – \$20.00) = \$500.00 per-contract
• Option profit = (\$1.00) -(\$6.00) + (\$13.00) = +\$800.00 per-contract
• Net profit = \$1300.00 = 65%

2- Assuming the stock closes at \$18.00 at expiration of the December contracts and stock is sold, is there a profit or loss and how much?

• Stock loss = (\$20.00 – \$18.00) = \$200.00 per-contract
• Option profit = (\$1.00) -(\$6.00) + (\$13.00) = +\$800.00 per-contract
• Net profit = \$600.00 per-contract = 30%

3- What could be the main reason to roll-down the contracts?

• By rolling-down, intrinsic-value of the lower strike is captured thereby developing additional downside protection of the current position

4- What would be the final results at the end of the August contracts if the stock price remains unchanged from \$35.00 and no rolling takes place?

• Stock profit = (\$30.00 – \$20.00) = \$1000.00 per-contract
• Option profit = \$1.00 = \$100.00 per-contract
• Net profit = \$1100.00 = 55%

5-When would be the best time to close the entire position?

When the time-value component of the option premium approaches \$0.00 mid-contract, the position can be closed and a new position opened with a different underlying. For example, if XYZ moves up to \$40.00 per-share and the \$30.00 call has an “ask” price of \$10.10, the time-value component is \$0.10 or \$10.00 per-contract. We can close and use the newly-generated cash to enter a new covered call position and, therefore, a second income stream. It should be easy to generate much more than the \$10.00 cost-to-close.

6- What are the main disadvantages of rolling-out several months?

• We are susceptible to one or more earnings report high-risk events
• Our bullish assessment of XYZ may not last through the new contract expiration
• Lower annualized returns

7- Which approach offers the best annualized returns?

No rolling-down (#4) offers the best scenario because it is a 1-month return of 55%, 660% annualized. Rolling-down and out to the December contracts offers an overall 65% return but since it becomes a 5-month trade, it annualizes to 156%

***This post represents an exercise in education as these numbers do not reflect a typical, conservative option-selling trade.

***Many thanks to KA Lau for sharing this challenge with our BCI community

Over the years, the BCI community has been incredibly gracious by sending our BCI team email testimonials sharing stories as to what our educational content has meant to their families. Moving forward, we have decided to share some of these testimonials in our blog articles. We will never use a last name unless given permission:

Hi Alan,

I have reading your books and watching your videos. This is one of the best investments I have done. Thank you so much for keeping them affordable and providing me with the wealth of knowledge to start on CSP and CCW.

Regards,

Jason

Upcoming events

1. February 6th – 9th 2020 Orlando Money Show

3- Hour Masters Class Saturday February 8th 1:45 – 4:45 PM

BOOTH 306

Information to follow

2. Tuesday March 10, 2020 Long Island Stock Traders Meetup Group

7 PM – 9 PM

Plainview- Old Bethpage Public Library

Covered Call Writing Blue-Chip Stocks to Create a Free Portfolio of Large Tech Companies

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2. Las Vegas Money Show: May 11th – 13th

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Market tone data is now located on page 1 of our premium member stock reports and page 8 of our mid-week ETF reports.

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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.

17 Responses to “Covered Call Writing Quiz: Evaluating a Series of Trades”

1. Brian January 18, 2020 3:30 am
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Hi Alan,

In going over the list as I am setting up to enter the trades with covered call expiration on 2/21, I found out that TTC has puny option trading Friday (may be a slow day Expiration Friday). Hope this is useful info.

Brian

• Alan Ellman January 19, 2020 6:11 am
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Brian,

TTC had several contracts with adequate open interest for the January contracts. That’s why the stock was eligible for consideration.

The report that came out last night, shows TTC still listed but with inadequate open interest. Let’s see if that changes when the market re-opens Tuesday and Wednesday. It may.

Alan

2. Barry B January 18, 2020 8:45 pm
#

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 01/17/20.

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:

Since we are starting Earnings Season, be sure to read Alan’s article, “Constructing Your Covered Call Portfolio During Earnings Season”. You can access it at:

https://www.thebluecollarinvestor.com/constructing-your-covered-call-portfolio-during-earnings-season/

Best,

Barry and The Blue Collar Investor Team

[email protected]

3. Cynthia January 19, 2020 4:55 am
#

Alan,

I recently became a premium member and have a question about the report that came out last night. I,m sure the answer is obvious but I don’t see it. Why do you include the stocks in the yellow cells if they aren’t eligible for the February options?

Thanks for all the work you and your team do to help us retail investors.

Cynthia

• Alan Ellman January 19, 2020 6:16 am
#

Cynthia,

Welcome to our premium member community.

During earnings season, many of the elite-performing stocks are highlighted in gold cells. We leave these stocks in our reports for several reasons:
1. These stocks become eligible for consideration after the report passes.

2. Some of these stocks have Weekly options which can be used with the exception of the week of earnings.

3. A small percentage of our member use these lists for just buying and selling stocks without the option components.

Alan

4. Tim January 19, 2020 11:20 am
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Alan,

Thanks for all the great information you provide. You had mentioned on a previous response that you wait until the the beginning of the next monthly option period before you begin to sell your options. Do you have a time period that you follow to sell your options? (i.e. do you sell all your options on the same day or do you spread them out throughout the week or weeks of the option period?)

Thank you,
Tim

• Alan Ellman January 20, 2020 6:35 am
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Tim,

My preference is to use Monthly options. I enter my new positions on the Monday or Tuesday after expiration Friday. This week, it will be on Tuesday because of today’s Martin Luther King holiday.

I will enter my trades between 11 AM and 3 PM ET to avoid early morning and late afternoon computerized institutional trading.
Since we are in earnings season, there are rare exceptions where I wait until later in the week if I want to use a stock from our premium stock report that reports in the first week of a new contract. In this scenario, I will execute the trade after the report passes.

I leave about 1 1/2 hours open in my calendar each month to enter 15 – 25 positions which translates to 50 -100 contracts. Most of the preparation was completed over the past weekend.

Alan

5. Ed January 20, 2020 2:39 pm
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Hi Allan,

Went through the 8 covered call beginners lessons, watching Puts now – thanks so much!

I really like your style, I grew nearby in Southeastern CT and your voice reminds me of my childhood – comforting. I can tell that you have a huge understanding of options and you present the material very clearly and in an organized fashion. I’m also very convinced that you are truly honest, not always the case with premium membership systems. So thanks again for that.’

I’m going to do your trial after we return from a holiday week coming up. Might get the Classics e-book as well. I did trade some simple options 15 years ago and have been investing (buy/hold IRA) for 22 years. I’m pretty up now and am looking at income supplementation (self employed) and downside protection. Got me back on the options wagon.

Ok, let’s say I make a covered call trade and want to immediately automate either a stop order or a profit taking order.

Another YouTube guy likes to set his automation (can only have one) in the direction of profit – he sets a 60% max profit and gets out there. He then sets an alert (text message) for the downside at some level to buy back the trade (spreads in his case.)

So, here’s my question (and thanks in advance for taking the time to read this and answer): when doing automation – do you go for the profit side or the downside?

Thanks so much!

Ed

• Alan Ellman January 21, 2020 6:30 am
#

Ed,

In the BCI methodology, we do not limit ourselves to one or the other. We can take advantage of both. Position management is a substantial part of our BCI methodology and a response in this venue cannot do it justice but I’ll give it my best shot with an overview response.

Since we are in 2 positions (long stock, short call), we must close the short call first with all of our exit strategy executions. When a stock is declining, we turn to our 20%/10% guidelines and then decide on the next step based on the thresholds detailed in my books/DVDs.

When a stock moves up in value, the use the “Unwind Now” tab of the Elite version of the Ellman Calculator to determine the time-value cost-to-close. If we can generate more than 1% more than the time-value cost-to-close by contract expiration, we use our “mid-contract unwind” exit strategy.

Finally, for members looking for a threshold when to sell the stock after closing the short call, a range of a price decline between 8% and 10% is reasonable.

The most important statement I can make in this (limited) response is that before entering a covered call (or put-selling) trade, we must master all 3 required skills… stock selection, option selection and position management. That will allow us to achieve the highest possible returns and beat the market on a consistent basis.

Alan

6. Dono January 21, 2020 2:12 am
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Dear Alan,

I have a small portfolio totaling not more than \$10,000. Currently my holding are consisted dividend stocks I followed from “dog of the dow”. My question is it alright to leverage my portfolio for covered call writing?

One of my criteria is Static Return between 2% to 4% per month. I think it should cover the interest margin. Thank you.

Best regards,

Dono

• Alan Ellman January 21, 2020 7:13 am
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Dono,

To be properly diversified with a portfolio of \$10k, we would turn to ETFs (baskets of stocks… mutual funds that behave like stocks). ETFs have less volatility than individual stock as a general rule and therefore will have lower premium returns. I would adjust my monthly goal to 1% – 2%.

Another, perhaps better, approach is to build up the cash available before utilizing conservative option-selling strategies. For that, I will refer you to my book, “Stock Investing for Students” which focuses in on broad market, low expense-ratio index funds.

Alan

7. Terry January 22, 2020 10:26 am
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Seasonality graph

8. Alan Ellman January 22, 2020 5:13 pm
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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.

Also included is the mid-week market tone at the end of the report.

https://www.thebluecollarinvestor.com/membership.shtml

Alan and the BCI team

9. John January 23, 2020 11:33 am
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Good morning Alan,

I just completed my 1st option trade using your data. The total trade was worth 4.9%, not too bad! I can live with that. I did write covered calls about 15 years ago but it became very time consuming searching for the “right” underlying security.

I do have a question. How far in advance should I buy(Feb.20) the new underlying security? Recognizing its only an approximate time period?

Thank you,
John

• Alan Ellman January 23, 2020 4:06 pm
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John,

Glad you’re off to a good start.

For those who prefer monthly expiration options as I do, entering the trade on the Monday or Tuesday after expiration Friday is best as waiting longer will expose us to the negative impact of Theta on the time-value of our option premiums.

Alan

10. Joe February 3, 2020 10:22 pm
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Pretty hefty assumption that a stock you bought on July 1st for \$20.00 has a value of \$25.00 the next day, and that is when you write the covered call?

My real life experience says that may happen once out of every 100 times.

Most of the time I purchase my monthly covered calls contracts as soon as I buy my 100 shares. Which is why I purchased the underlying because of the nice premium I am getting for the covered call.

Can you use the example as if you purchased the contract the same time you bought 100 shares. That would seem to be more realistic and probably brings down the hefty percentage gain in your blog post.

To tell you the truth, maybe even do an example where you bought a stock for \$20 – waited a day and it dropped to \$15 a share. Thats why I always write my covered calls as soon as I buy the 100 shares.

Thanks.

• Alan Ellman February 4, 2020 6:42 am
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Joe,

I agree with you 100%. The scenario presented in this hypothetical trade is atypical.

This site, along with all our educational products, shows examples of trades ranging from commonplace to peculiar like this one. Why not explore all possibilities?

This article was a response to KA’s hypothetical. Although divergent from most of our trades, I felt it was worthy of a response.

Alan