When we initiate a covered call trade by first buying a stock and then selling a call option, our cost-basis, in the BCI methodology, is the lower of the stock price or strike price. If we sell an in-the-money (ITM) strike, we deduct the intrinsic-value component of the option premium from the share price bringing our cost-basis down to the ITM strike price. When we sell at-the-money (ATM) and out-of-the-money (OTM) strikes, the cost-basis is the stock price. This is all pretty straightforward but what if we have previously executed covered call trades with this stock and retained it in our portfolio? What if we decide to write calls on stocks we’ve held for long periods of time and are now at a much lower cost-basis than current market value? This article relates to an email sent to me in August 2020 from Stephen who was inquiring about his cost-basis as he continued to sell covered call options on Bank of America Corporation (NYSE: BAC).
Summary of Stephen’s trades with BAC
- Buy 100 shares of BAC at $24.10
- Current price $26.10
- Total per-share option premiums collected to date: $2.80
- Cost to buy back current $24.00 short call is $2.20
Stephen’s dilemma
Stephen wanted to establish his cost-basis so as to make the best strike price selections. He was considering one of the following:
- $24.10
- $21.30 ($24.10 – $2.80)
- $26.10
Do not comingle 2 completely different sets of calculations
We can view these trades through 2 sets of lenses: overall trade results and current trade situation. Are we evaluating where our series of trades stands as a final calculation or are we evaluating our trading decisions based on current information? If we wanted to evaluate our stock position with BAC to-date, our cost-basis has been lowered to $21.30… we paid $24.10 and received $2.80 in option premium.
If we were considering rolling the, now, ITM $24.00 call versus allowing assignment, we must ask ourselves what are our shares worth today? Prior to rolling the option, our shares are worth $24.00, our contract obligation to sell at the strike price. If we allowed assignment, that’s how much we would receive. To compare apples-to-apples, we must use $24.00 as our cost-basis, so none of the 3 choices Stephen was considering would be accurate for this specific purpose.
Calculating our rolling returns
Using $24.00 as our cost-basis and $2.20 as our cost-to-close the $24.00 call, Let’s use the What Now tab of the Ellman Calculators to see if the returns meet our 1-month initial-time-value return goal range. Let’s assume the next month $24.00 call generates $3.00 and the $27.00 call generates $0.50.
Rolling data entry
BAC Data Entry Into The Ellman Calculator
Rolling calculations
BAC Rolling Calculation Results
Rolling-out results in a 3.33% initial time-value return with an 8.00% downside protection of that initial profit. Rolling out-and-up results in an initial time-value return of 1.67% but with upside share appreciation, a potential 5.42% 1-month return if BAC moves up to the $27.00 strike by expiration.
Discussion
It is critical not to comingle 2 different sets of calculations when making our trading decisions. Our current trades should be based on current statistics while long-term evaluation of a series of trades will be based on longer-term data.
Covered call writing calculators available
Elite Calculator for Covered Call Writing
Elite-Plus Calculator for Covered call Writing, Put-Selling and Total Portfolio Analysis
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Hi guys,
I’ve just come across your site when googling about my latest options strategy.
It would be great to run it by you as I am a novice when it comes to options.
I believe a stock will drop considerably in share price in the next few months so I thought buying put options would be a good strategy.
Returns Profile: I have opted for this strategy as I want to contain potential losses to 100% of my original stake and have the potential for unlimited gains.
As shares of the company in question are very volatile the premiums for the near the money and slightly OTM put options are considerably high.
That got me looking at deeply discount out of the money put options. Not dissimilar to penny stock trading, the plan would be to buy these options (that are highly unlikely to be exercised), wait for a bout of volatility in which the underlying share price drops considerably, then hope to see the price of the options jump from a very low level to a slightly higher level.
As the price of these put options is minimal ($0.01 ~ $0.20$) it doesn’t take much to see multiple returns if the prices moved in your favour.
One issue I see is finding a buyer of your options when you want to sell.
Another is that time value will massively affect the prospects of the price of the option. The less time the lower valued the option. Therefore I’d look to go as far out as possible.
Does this make sense at all?
Is there a better way of playing this type of trade?
Many thanks,
David
David,
Let me start by saying that I admire those who think “outside the box” and are looking for ways to enhance returns. That said, let me also say that “there is no free lunch” There is always someone taking the other side of our trades. Let me offer some thoughts for your consideration:
1. Yes, buying puts is appropriate if we anticipate share decline. In our BCI community, we favor being on the sell-side of options. This is where I’ve enjoyed my greatest success. When we buy options our loss is, as you stated, limited to 100% of our investment… that’s a lot!
2. Volatile stocks do offer higher option premium returns and unlimited upside… agreed. Volatility does not define direction, just degree of price movement anticipated.
3. Exercise is up to the option buyer, no one else.
4. If we buy deep OTM puts, the cost is low but so is the Delta. This means that for every $1.00 change in share price the option price will move only a small percentage of that $1.00 change. Another factor against this strategy is that we are fighting Theta (time-value erosion). So tiny movements due to Delta must overcome Theta and then some to make a profit.
5. Regarding “finding a buyer”, we should only deal with options that have adequate liquidity (open interest). This applies to those on the buy-side or sell-side of options.
I suggest paper-trading this strategy and comparing to strategies on the sell-side before embracing either approach and then you will be able to make an informed decision.
Alan
Alan,
How can I Manage a trade when I can’t always be in front of a computer all day. Do you put a stop to it? I would like to be a member but don’t know if I can with a full time job.
Thanks,
Jason
Jason,
Yes, we can take advantage of these strategies while working full-time jobs. I spent many years of my professional career trading options while managing a large dental practice until I decided to make a career change.
The research can be done at night and on weekends. We do need to be available at least twice a month during trading hours to enter trades and roll options at the end of a contract. The exit strategy aspect can be mostly automated by using the 20%/10% guidelines explained in my books and online video courses.
Start out with a small paper-trade (practice) account. It will take 3 – 4 months for the education and practice. By that time you will be able to assess the practicality of working and generating cash-flow by selling options.
You are off to a great start by asking the questions and doing you due-diligence.
Alan
Hello Dr Ellman,
I am struggling a bit on correct figure to use on the multiple tab of the elite-plus calculator. Perhaps I am using the wrong calculator for “hitting a double”. I purchased 100 RDFN on 2/25/21 for $79.05 $/sh. I then sold the $80 5/21/21 call for $10.55 $/sh. My 20% exit at $2.12 was executed today 3/5/21. The stock rose back up this afternoon and I resold the same strike and expiry date at $3.25 $/sh.
What figure do I use in column E of the EP Cal? Do I subtract the realized TV from the purchased stock price? $79.05 – 8.43 = $70.62 Stock $/sh.
Which then brings up column F. If I use $3.25, it skews the return since this number is 70% less than the initial $10.55 Should I be adding the $3.25 to the $8.43 realized = $11.68 for column F. This then affects the 20/10% columns.
I attempted to use the “what now” tab but there isn’t anything for simply ‘rolling’.
thank you in advance for providing me clarity on how to input “hitting a double”.
Kind Regards
Duane
Duane,
Really nice job on this trade. Plus you made sure to avoid the 5/26 earnings report… impressive.
In the screenshot below, the Elite-Plus Calculator (multiple tab) shows an initial 3-month time-value return of 13.30%, 53.2% annualized.
Now, the “hitting a double” exit strategy can be calculated as follows using this same spreadsheet:
Everything stays the same with the exception of the net option premium… same stock, same strike, same contract expiration, same cost-basis but option premium changes: $10.55 – $2.12 + $3.25 = $11.68.
Simply change $10.55 in column E to $11.68 and the calculator will show a ROO of 14.80%, 59.2% annualized. This exit strategy results in a 3-month return increase of 1.5%, 6% annualized.
My team and I are working on as new trading log which will enhance our ability to manage and archive all our trades. We hope to have this available to this BCI community within a few months.
CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.
Alan
Dr. Ellman
Thank you for the clarifications. I woke up in the middle of the night and came to that conclusion as well. The only thing was that it obliterated my previous position like it never existed.
So my second thought was I’ve got to build a spreadsheet 2 contain all of my previous trades and I see you’re already working on it. fantastic! Hopefully it will be where we can see our monthly totals in dollars and annualized monthly return percent. Then I could start a new spreadsheet for year.
I now have two and a half months to hit that rarefied triple. I realize it’s cheating a bit on the time frame. hehe So perhaps if I had a quadruple (Home Run – Go Rays!), I can get that coveted post on your website that you spoke of in your “exit strategies for covered call writing”.
Kind Regards
Duane
________________________________________
Duane,
When you hit that “triple” or “4-bagger” send me the stats and I will create the article and share with the BCI community.
All this is quite appropriate now that spring training has started.
Alan
Hi Alan,
At the beginning of this contract cycle, I purchased contracts in BLOK and ARKF. ARKF wasn’t on the weekly report but it passed all the BCI criteria so I liked it and invested in it. Both ETFs declined since I purchased them. I purchased them because the financial sector was doing well and both were related to that sector. Their technicals weren’t weren’t the best so I sold ITM. After both ETF’s price declined for what seemed like an eternity, I sold both today when the VIX was 29. Since then the VIX has dropped to 24.71 and both ETF’s prices have increased. I wish I could have had two additional hours of patience lol
After listening/reading about recent events, my guess is there are inflation concerns and those concerns have led to a sell off of growth stocks. I speculate this undercurrent may have contributed to the declining price of both ETFS? Do you have or can you refer me to a good resource on sector rotation? I am guessing there is an opportunity for me to better see the market and I hope this will help me pick better ETFs.
Thanks for your time,
-Nathan
Nathan,
An excellent free resource to visualize sector rotation is located at the link below. The Select Sector SPDRs divide the S&P 500 into 11 distinct sectors and price-performance can be accessed in multiple time-frames.
https://www.etfscreen.com/s_selects.php
Alan
Alan,
I am a BCI premium member and I have a question about monitoring my trades. I am using cash-secured puts and I sold puts in 5 different securities (all from your weekly stock report) on February 22 for the March 19 contract. I looked at the trades this morning and one (BEKE) was more than 3 % below the 55 strike that I sold (using your guideline of closing out the cash-secured puts). I also had AMAT and it was trading about a little above 107 and I had a cash-secured put at 110. I saw the market was dropping the last couple of days and closed out the AMAT put even though it was not quite 3% below my strike. It was market tone, not AMAT that bothered me. Well, by close of market, BEKE was still over 3% below my strike (it had gone down more during the day and then rose some to about 52), while AMAT went back up to about 112, well above my strike.
The question I have is about timing . From one of your Resource/Download PDFs, you talk about watching the market and your trades and getting a feel for market tone early and seeing if there any issues with your particular trades and then checking late in the afternoon, near market close. There was no issue about my securities (BEKE and AMAT). Should I have been obsessing about watching and acting throughout the day or should I just see where things are at the end of the day. It turned out that the general market went down early and then recovered some later. I know that general guidelines are just that, not hard and fast rules, but is waiting to the end of the day to see what has happened generally OK and certainly easier than taking exit strategies during the day as soon as you see them happen?
BTW, I am selling OTM cash-secured puts with low deltas just so that I will have fewer exit strategies to execute and generate returns of around 2% in general.
Thanks.
Bill
Bill,
For covered call writing, we can set 20%/10% BTC limit orders and practically automate the process on the option side. For put-selling, we must keep an eye on share price but do not need to spend the entire day watching our computer screen. Check with your broker to see if they offer some sort of alert service that may support our approach.
If not, I would check share price at least twice a day. First, late morning (ET) after early morning volatility subsides and then again maybe an hour prior to market close.
Nowadays, with phones and watches that give this data, once this routine is established it will become easy and practical to accomplish.
Selling deep OTM cash-secured puts when market volatility is high is a reasonable approach to mitigate risk.
Alan
For a stock that has dropped in value, I was wondering if you can see any beneficial scenario in selling cash-secured puts via a straddle/strangle (along with covered calls) as a hedge versus buying puts. I guess it would be an averaging-down wheel strategy on a bearish stock.
I can see the risks if the stock gaps down further and assignment occurs, but the upside would be a premium paid to limit downside along rolling potential instead of paying a premium for protection. Assuming assignment, ITM or ATM covered calls can be opened on the new shares.
I believe that It would need to be in a stock that I would want to own long-term anyway.
Thoughts? Sorry if is a confusing read
Robert,
When share price drops (and no option component), we can lower our cost-basis without adding additional cash to the trade ( averaging down) by using the stock repair strategy. Here is a link to an article that explains the process:
https://www.thebluecollarinvestor.com/stock-repair-strategy-using-stock-options-to-reduce-losses-when-stock-price-declines/
BCI has also developed a calculator specific for the stock repair strategy:
https://thebluecollarinvestor.com/minimembership/stock-repair-calculator/
Alan
Awesome and thanks for the answer. I’m enjoying and apreciate everything that you do for investors!
Premium Members,
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 03/05/21.
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:
http://www.youtube.com/user/BlueCollarInvestor
On the front page of the Weekly Stock Report, we now display the Top 10 ETFs, the Top SPDR Sector Funds, and the 4 single Inverse Index Funds. They are sorted using the 1-month performances from the Wednesday night ETF report and the prices from the weekend close.
Best,
Barry and The Blue Collar Investor Team
[email protected]
Premium members,
We have updated the most recent ETF Report to reflect the fact that MJ does, in fact, have Weekly options. Thanks to Ed for bringing this to our attention.
Alan
Premium Members,
The Weekly Report has been revised and uploaded to the Premium Member website. There was a change on the first page in the “Prices As of Close” in The Weekly ETF Summary section. It now shows the correct date. In the same section, MJ was also updated to indicate that it has weeklies. Look for the report dated 03/05/21-RevA.
Best,
Barry
DOW 62.50 March 19th covered calls.. Trading at about 63.5 plus or minus for the day.
Somebody called the contract mid cycle!
Geez i hope they made a typo. I cannot imagine that strategy!
Best
Scott
Scott,
Very rare. Someone made a mistake and it wasn’t you. You maxed your trade results and now have the cash back to re-invest and generate a 2nd income stream. Enjoy the ride… Alan
Dear Dr Ellman,
I have a problem that I don’t know how to solve and I am hoping you could guide me.
On Mar 1/21 I sold AXP call at a strike price of $144.0 for a premium of $105.35 . The stock price on that date was $138.73 per share.
I will have a capital gain on the sale of the stock of $ 6,444.0 if I get assigned.
To avoid getting assigned I want to buy the option but the lowest strike price available is $147.0 which is $3.0 higher than the option I sold. How do I solve this problem?
I have 4 more days before the option expires. I will be most grateful for your help.
Sincerely/Jorge
Jorge,
Glad to help.
The $144.00 strike is still available to trade. Just expand your view of the option-chain. Below is a screenshot of the strike information taken from the cboe.com site pre-market this morning.
CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.
Alan
Dear Alan,
I sold a cash covered put on ZM when the stock was at $440. My expiration date is 3/19 and my strike price is $350.
Now the stock price is $310. Should I hold the option and after it is exercised and write a covered call on the stock?
Or should I try to get out now. Is it possible that the option price will go down enough to get out the last two days of the contract?
I have only been trading options for 3 weeks and your videos have helped me tremendously.
Thank you for your videos. I have made about 22 trades that are good but I got suckered in to ZM because of the large premium. Dumb mistake. What should I do now?
I tell everyone about your website and videos!
Thanks again,
Jim
Jim,
Every trade, even losing trades, are valuable to our long-term success. We always benefit from lessons learned. This trade may or may not turn out to be on the debit side of the ledger. Although I cannot give specific financial advice in this venue, I can make some general comments that you should find useful:
1. We can allow assignment of a cash-secured put when the bullish assumptions that led us to using this security are still in place.
2. We can also allow assignment if this is a stock we want to keep in our portfolio either as a long-term holding or to write a covered call. We ask ourselves: “Would I buy this stock today and the current price based on the information available?”
3. Stocks that generate high premiums have high implied volatility. That same IV creates greater risk to the downside. Does this approach align with our personal risk-tolerance?
4. The BCI guideline for cash-secured puts is to close the short put if the stock price moves >3% below the strike, $339.50 in the case of ZM. This will usually result in a small loss and protect us from a bigger hit.
5. ZM is up $14.00/share pre-market this morning as I type.
ZM is a great company with a high implied volatility stock. This is appropriate for some and not for others. This trade may turn out to be a winner or a loser. The important point is to learn from it no matter which side of the ledger the final results fall.
Alan
Thanks for your help and response. What you do is very valuable!
Premium members:
This week’s 4-page report of top-performing ETFs and analysis of the top-performing Select Sector SPDRs has been uploaded to your premium site. One and three-month analysis are included in the report. Weekly option and implied volatility stats are also incorporated.
The mid-week market tone is located on page 1 of the report.
For your convenience, here is the link to login to the premium site:
https://www.thebluecollarinvestor.com/member/login.php
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Alan and the BCI team
Hi Alan,
Good day.
I was trying to follow your strategy of selling way out of the money puts.
During the last sell off, even the ones that were under 10% (i always chose the first one under 10%), they all got caught.
What is your take on that?
did you have the same results? I know in the past you said only 1 time your puts got exercised on ETSY, but with that great selloff, it seems all got caught?
Thanks
Amit.
Amit,
I had 2 situations that the <10 Delta puts were exercised. Both were related to ETSY. The first time, I sold ETSY for a $2500.00 profit the Monday after expiration. Today, I sold ETSY for a $1200.00 profit, 4 trading days after the last expiration.
Only sell puts on shares you would not mind owning and anticipate that a small percentage will be expiring ITM.
I consider this approach one of the solid strategies available to option-sellers.
Alan
Hi Alan,
I hope you are doing well. I am looking forward to The Money Show next week. Thanks for the invite.
I have a question that has me baffled and have been unable to get a satisfactory answer from anyone. I probably should have asked you first…..since you are The Man!!!
I bought 100 shares of RKT and have been selling “Covered Calls” against the position. It has been moving along nicely.
BUT
The other day, they announced a “Special Dividend” of $111
At first glance I was very happy. That is a very nice dividend.
Then, looking closer, they also reduced all the option strike prices by the same $1.11
Now the March 19 strike that I sold at $28 is now going at $26.89
The stock closed today at 25.83 but has hit 26.89 everyday now since the special dividend.
My dilemma is that I will be called away at 26.89 instead of 28.
In the end, I will make the same amount as I originally planned if the stock was taken away at the 28 strike because they say I will be getting the $111 dividend. But because I now will have the stock take away at 26.89, I am losing $111 in stock appreciation.
SO BASICALLY……THIS SPECIAL DIVIDEND DOES NOT BENEFIT ME IN ANY WAY…..unless the stock closes below 26.89 next week but it doesn’t seem likely to me. I could also try to buy back the call and close the position but that results in a debit and I would not rather add to my cost basis.
WHAT’S THE DEAL WITH THIS “SPECIAL DIVIDEND?” It doesn’t sound special to me!!!
Any explanation or advice would be greatly appreciated.
All the best,
Ron
Ron,
There is nothing to be concerned about here. When a company announces a 1-time special cash dividend, the price of the stock will drop by that dividend amount an the ex-dividend date. This the reason the OCC adjusts the strike prices… to make buyers and sellers of options whole.
If a covered call writer owns the shares on the ex-date, that investor will capture the dividend even if the option is exercised after that date.
The maximum return will be realized if RKT closes at or above $26.89 at contract expiration.
Alan
Thanks for getting back to me Alan.
Yes I understand completely. I will get my “original” max return if RKT closes above 26.89
The “problem” is I do not get the $111 special dividend.
Yes I will receive it after the position has been assigned but I also gave away my shares $1.11 below the original strike…..so it is a total wash.
In this particular situation, the way it stands now, I do not see any benefit to me, the actual shareholder. Of course if the stock closes next week below 26.89 or I am able to buy the calls back at a lower cost, then I will be singing a different tune.
I guess I just wait and see.
Ron
Ron,
It is a wash. The value of a company includes the cash reserve. If a percentage of that reserve is distributed in the form of a dividend, recurring or special, the value of that company decreases by the dividend amount on the ex-date.
If we own the shares on the ex-date, we receive the dividend on the distribution date independent of exercise.
The OCC adjusts the option contracts such that buyers and sellers of calls and puts remain whole.
Bottom line: A special 1-time cash dividend is a good sign for a company (that’s the positive of this scenario) but does not enhance our portfolio value. As option-sellers, we do not win or lose.
Alan