Establishing Our Cost-Basis in a Multi-Step Managed Trade

Covered call writing calculations are meaningful only when the correct stats are entered into our formulas (calculators). The cost-basis of a managed trade can be confusing as stock and option values are changing with each step of the trade series. In July 2020, Steve shared with me a series of trades he executed with KraneShares CSI China Internet (NYSE: KWEB). The sequence of trades involved opening a covered call position, rolling out-and-up and finally the mid-contract unwind exit strategy where both legs of the trade were closed. This article will explain the cost-basis that should be used to make the calculations most useful to our trade decisions and evaluations.

Steve’s trades with KWEB

• 6/08/2020: Buy 200 shares of KWEB on at \$56.50
• 6/8/2020: Sell-to-open (STO) \$56.00 strike at \$1.65 for the 06/19/20 expiration
• 6/19/2020: KWEB went up to \$61.00 on expiration Friday
• 6/19/2020:  Rolled-out-and-up
• 6/19/2020: Buy-to-close (BTC) the \$56.00 strike at \$5.90
• 6/19/2020: STO the \$61.00 7/19/20 expiration at \$2.90
• 7/06/2020: BTC the \$61.00 strike at \$6.95 as the stock was at \$67.64
• 7/6/2020: Sell the stock @ \$67.64

KWEB: Initial covered call writing calculations (6/8/2020)

KWEB: Initial Calculations with the Multiple Tab of the Ellman Calculator

The trade was established with a 2.1% initial time-value return with 0.9% downside protection of that time-value profit. The cost-basis for this leg of the trade series was \$56.00 after deducting the intrinsic-value component of the \$1.65 premium from share purchase price.

KWEB: Rolling-out-and-up calculations (6/19/2020)

KWEB: Rolling Calculations with the “What Now” Tab of the Ellman Calculator

Factoring in the bought-up value of KWEB (shares worth \$56.00 with the \$56.00 strike in place, are now worth \$61.00), the initial 1-month return is 3.57%. The cost basis for this leg of the trade remains at \$56.00 because that is what our shares are practically worth as the rolling-out-and-up exit strategy was initiated.

KWEB: Mid-contract unwind exit strategy (closing both legs of the trade on 7/6/2020): Total return from 6/8/2020 to 7/6/2020

Stock position: +\$11.14 (\$67.64 – \$56.50)

Option position: -\$8.30 (+\$1.65 – \$5.90 +\$2.90 – \$6.95)

Net position: +\$2.84 (\$11.14 – \$8.30)

1-month total trade return: \$2.84/\$56.50 = +5.03%

After calculations credits and debits, we divide by our initial investment of \$56.50 per share to determine our overall return result. When calculating taxes, if trading in non-sheltered accounts, different stats are used. The ones utilized in the BCI methodology are based on allowing us to make the best trade decisions at any given point in time.

Discussion

Option-selling calculations allow us to make the best trading decisions every step of the way. Should we roll-out or allow assignment? The cost-basis should be the value of the stock at that point in time. The Elite-Plus Calculator will go a long way in assisting with these decisions.

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29 Responses to “Establishing Our Cost-Basis in a Multi-Step Managed Trade”

1. James January 30, 2021 2:11 am #

G day Alan.

Read your book on exit strategies which was fascinating I have a few questions I would like to ask you.

Firstly is having a stop loss on covered calls a waste of time?

Secondly if a trade has a delta of .3 Does this mean it has a probability of 70% success Also what is delta 10.This is not shown on option chains?

Thirdly with a bull put spread do you sell put and buy put simultaneously ?

Thanks,
James

• Alan Ellman January 30, 2021 5:38 am #

James,

My responses:

1. After entering a covered call trade, it is essential to place a buy-to-close limit order (20%/10% guidelines) on the option side of the trade. This is the equivalent of a stop-loss on the option. After that, we make our next-step plan.

2. A Delta of .3 implies a 30% likelihood of the option expiring in-the-money or with intrinsic-value or a 70% likelihood that exercise will not occur. Keep in mind that trade can be successful with or without exercise. Also, we can prevent exercise simply by buying back and in-the-money strike prior to contract expiration. Delta is usually shown in option chains as per-share stats. The Delta of a contract is 100x that stat. A Delta of 10 per contract will be shown as a Delta of 0.10 in a typical option-chain.

3. Yes.

Alan

2. Jorge January 30, 2021 6:54 pm #

Alan,

A few of my btc orders were set off on Friday. How long should I wait to roll down or hit a double?

Thanks a lot.

Jorge

• Alan Ellman January 31, 2021 6:51 am #

Jorge,

Several of mine were executed as well. I actually “hit a double” on a few contracts last week.

The February contracts span a 5-week time-frame. We are entering week 3 of the contracts. I view this as the same as entering week 2 of a 4-week contract. This week, I will be looking to hit more doubles unless the market continues to decline. If those opportunities do not present, I will turn to rolling-down in the latter part of the week and early the following week. It’s a long way to the 19th.

It is critical to stay focused and trade in a non-emotional manner whether the market is accelerating or declining.

Alan

• Roni January 31, 2021 8:53 am #

Alan,

you are the “Ice Man”, hiper cool.
I will try to imitate you despite the temperature here in Sao Paulo of 32C = 90F.
The market decline last week was scary and I also had some BTC orders executed at 20%, and some others almost there.

Your post is very valuable to me.

Thank you – Roni

3. Barry B January 30, 2021 8:48 pm #

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 01/29/21.

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:

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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.

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4. Duane January 31, 2021 11:17 am #

Thank you for your reply to Jorge. It was very helpful to me on your comment concerning the time frame of when you start looking to roll down after checking the doubling opportunities. The sudden dips and spikes this past week has turned me bearish until this GameStop mess shakes out. Reminds me of the dips with small rallies as the market stair stepped down in March of 2020. Makes me think of a floor or ground cracking before the inevitable cave in (Sinkhole for those in Florida) effect.

• Alan Ellman February 1, 2021 6:58 am #

Duane, Roni,

We must be prepared for every possibility. We can always look back and feel that had we taken another approach, we would have had a better result. However, by taking a structured, non-emotional approach based on sound fundamental, technical and common-sense principles, we will come out ahead more often then not.

What occurred last week with GME and in March with the COVID-19 crash were aberrations. I believe in a reversion to quality and that is what the BCI screening methodology is all about.

Alan

• Roni February 1, 2021 9:26 am #

Thank you, Alan.

5. Andrew January 31, 2021 5:16 pm #

Hi Alan,
What are your thoughts regarding the bubble of GME etc. stocks? Can this have a ripple effect on S&P and other stock exchanges?
The big boys will have to pare their portfolios to cover their shorts, which can lead to a domino effect on the stock exchange.
From Monday onwards billboards will start appearing in New York with signs “Go to the Moon” regarding GME stock.
SEC, it seems, doesn’t have any real appetite to interact in this epic on going fight.
Maye we should go Long on Puts (protection)? If the above scenario does occur, then these Puts will increase in value exponentially.

Regards

• Alan Ellman February 1, 2021 7:08 am #

Andrew,

Do we view the GME phenomenon a more impactful event than COVID-19, 0% interest-rates, economic data, positive earnings season etc.? If no, nothing changes.

This does not mean that we shouldn’t take short-term precautions until there is clarity with how the unwinding of GME and others will occur.

This can mean protective puts, selling deep OTM cash-secured puts to enter covered call trades, using low implied-volatility securities and setting lower initial time-value return goal ranges.

All of these approaches have been part of the BCI methodology for more than a decade… this isn’t our first rodeo with GME and the like.

Alan

6. Roger January 31, 2021 6:36 pm #

Hi Alan,

Just a few days ago I purchased shares of DQ (Daqo New Energy Corp) for \$107.65 and sold the Feb 19th 110 strike (\$11.50). Since then, the stock price dropped considerably to \$88.06. The option price has not reached the 20% guideline to buy back yet. If it does before the end of this upcoming week, I am looking at 2 choices in regards to a mid-contract unwind strategy: 1) buy back the option and then hope the price recovers so that I can execute the “hitting a double” strategy. 2) buy back the option and roll down to a lower strike price within the same contract month.

In this scenario, what guidance can you provide to help me decide which mid-contract unwind strategy I should choose.

Thanks,

Roger

• Alan Ellman February 1, 2021 7:24 am #

Roger,

The option sold generated an initial 1-month time-value return of 10.7%, 128% annualized. This means we are dealing with an extremely high-volatility security. Great premium return but higher-risk investment.

The breakeven is \$96.15 and the stock is trading at \$90.63 pre-market this morning. We are long way from the 2/19 expiration so we keep the 20% BTC limit order in place and monitor the trade. Keep in mind that I use the term “guideline” so a price close to the 20% threshold is okay to close as well. If the short call is closed, we base our next-step decision at that time.

We certainly CANNOT conclude that this, ultimately, will be a losing trade.

Alan

• Roger February 1, 2021 8:34 am #

Thanks Alan.

Hypothetically speaking – if the 20% BTC threshold was met today and the short call was closed, what can help me decide between waiting to see if I can “hit a double” or simply just rolling down right away for this particular security under these present conditions?

Thanks,
Roger

• Roni February 1, 2021 10:34 am #

Roger,

your question is everybody’s question, myself included.

When Alan says we must avoid emotions, he means # 1 Fear and #2 excess optimism.

So you must decide exclusively on good information and common sense, and then, we must be patient.

One more thing, we must avoid greed. 10.7% ROI in one month is a huge risk.

Roni

• Roni February 3, 2021 3:03 pm
#

Roger

DQ at 120.59, now you look real good.
A big risk but also a big gain.

Good luck – Roni

• Marsha February 3, 2021 8:51 pm
#

Wow, what a come back!

Happy for you.

Marsha

• Alan Ellman February 1, 2021 4:02 pm #

Roger,

Nice rebound for DQ today so no options closed.

Had the 20% threshold been met, the BCI guidelines lean to “hitting a double” in the 3rd week of a 5-week contract and to rolling-down thereafter. These are “guidelines” and market conditions (extreme volatility, as an example) may cause us to “tweak” these parameters.

Alan

• Roger February 4, 2021 5:32 am
#

Yes – I was happy to see that about DQ. Still mentally prepared for more volatility though.

Thanks again for the guidance. It’s definitely boosting my confidence.

Roger

• Barry B February 1, 2021 12:28 pm #

DQ is up \$12.83 at 12:25 PM EST. According to the news on Schwab, Asian stocks are up 2+% mid-morning.

Best,

Barry

7. Sara February 1, 2021 2:45 am #

Alan,

This week there are no stocks in Bold – does this mean due to a volatile market, pretty cautious moves not to take any positions this week ?

Thanks,
Sara

• Alan Ellman February 1, 2021 7:33 am #

Sara,

No, not necessarily. The market decline impacted the technical picture of our screened securities so none have all bullish technical signals. The “eligible” securities have mixed technicals and those are okay to use. These are the stocks that have held up best under market pressure.

However, if our personal risk-tolerance is such that we want to avoid these volatile events, then staying on the sidelines temporarily may make sense.

As I have documented in our premium member reports, I am currently 100% invested. This is right for me and may or may not be right for others.

Alan

• Michael February 1, 2021 7:39 am #

Alan,

I just watched your “when to roll out or roll out and up video”, thanks for that…

The spreadsheet all makes sense but if your original decision to purchase a stock and sell a call garnered lets say 2.1%, and then you decide to roll out you may wipe out .5 to .75% of your original investment and only take 1.5% of the original investment?

I understand at this point the upsides to this, you get a couple extra days of time value on the next month call (lets say Thursday afternoon or Friday morning versus the following Monday or Tuesday)…

Do you go back and update your prior month position returns for these BTC losses to “hold yourself (ourselves) accountable” to our actual returns? Am I missing something?

Thanks,
Michael

• Alan Ellman February 2, 2021 6:15 am #

Michael,

There are 2 sets of calculations we must not comingle… calculations to assist us on trading decisions and final results.

When rolling options, the implication is that the near-month strike is in-the-money and we have maximized our current contract month returns. That’s done… money in the bank.

Now, should we roll or allow assignment? Our shares are worth the current month strike, no more. When calculating the rolling returns, we add the next month time-value and subtract the cost-to-close and divide by the current strike. If rolling out-and-up, we factor in any increase in share value (discussed in my books/videos). The reason we consider rolling is that the time-value return meets our stated return goal range on a stock we want to include in our next-month’s portfolio (no earnings report). If the “deal” is there, take it… it may not be there on Monday.

Not all ITM options should be rolled. there are times we should “allow” assignment. The BCI Calculators were created to assist with these investment decisions.

Alan

• Sara February 2, 2021 6:41 am #

Alan,

Due to so much volatility, I started doing more of Cash Secured Puts on stocks that I like as well as some IPO’s with low price, so I can have some cash coming in (although it is not as much money) and/or get the stock at discounted price. Is this a good strategy or am I taking too much risk getting the stock and if the stock goes much further down due to these market conditions?

Sara

• Alan Ellman February 3, 2021 5:18 am #

Sara,

Sound thinking on your part.

The use of cash-secured puts is an outstanding strategy (as is covered call writing) to generate cash-flow. We use underlyings that we would not mind owning in our portfolios. The 2 outcomes are to either generate cash-flow or buy that stock (ETF) at a discount. If the shares are “put” to us, we can then write covered calls.

IPOs fall into a higher-risk category. I usually avoid these in my conservative option-selling accounts.

Alan

8. James February 3, 2021 2:39 am #

Alan,

Can you BTC before the expiration date and keep the share appreciation if its over the strike price.

Like if you STO strike @48.00, strike is 50.00, goes to 51.00. Can you sell before expiration and keep appreciation?

Also if you have an option on a stock can you just sell the stock shares first Or do you have to BTC option first.

Thanks,
James

• Alan Ellman February 3, 2021 6:01 am #

James,

My responses:

1. Yes, we can BTC at any time.

2. If we BTC an ITM strike, the cost-to-close will include the intrinsic-value of \$1.00 (\$51.00 – \$50.00) plus a time-value component… so we pay for that \$1.00 of share appreciation + a time-value component.

3. We must close the short call first or find ourselves in a risky naked option position. Most brokers will not allow retail investors to sell naked call options.

Alan

9. Alan Ellman February 3, 2021 5:27 pm #

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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.
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