After executing our covered call writing trades, we immediately prepare for position management opportunities…exit strategies. One of these strategies in our arsenal is the Mid Contract Unwind exit strategy. This is used when share value appreciates dramatically resulting in a time value cost-to-close of near zero. In other words, the option originally sold will be trading near parity (intrinsic value only). Having maxed the original trade, closing at a cost of near zero will allow us to use the cash from the sale of the stock to generate a second income stream in the same contract month with a covered call position using a different underlying security. The better our timing with these exit strategies the greater our level of success.
Real life example: Harley Davidson Inc. (HOG)
On July 1, 2016, HOG rallied nearly $9.00 per share on reports of a potential buyout. Here is a look at the gap-up in price that day:
With the stock now trading at $54.25, the $45.00 call option was deep in-the-money and trading near parity. The cost to close at this time was $9.50 which consisted of $9.25 of intrinsic value and $0.25 of time value. The practical cost-to-close is $25.00 per contract plus small trading commissions. We get to this $25.00 figure by deducting the increase in share value buying back the option produces. Prior to closing the short option position, our shares can be worth no more than $45.00 per share, our contract obligation. After buying back the option our shares are now worth market value or $54.25. It we can then take the cash generated by selling the stock to generate a second income stream in the same month with the same cash we have made greater than a maximum profit for the month.
Why act immediately when the opportunity arises?
There are two reasons why we should react reasonably quickly when these opportunities arise:
1- Share price can decline resulting in a higher cost-to-close.
2- Theta is reducing the time values of the second option positions as expiration approaches.
Two days later
HOG experienced some negative news about the buyout resulting in several analyst downgrades causing share value to decline from $54.00 to $47.66. With the $45.00 not nearly as deep in the money at this point in time, the time value cost to close moved up to $0.89 ($3.55 – $2.66), more than triple the amount had we acted sooner:
The time value cost-to-close is now $0.89 ($3.55 – $2.66) about 3 1/2 times more than it was two days prior to the price decline. We also find ourselves with two days less time value to generate with our second income-generating position as Theta is eroding option premiums.
There is more to position management than executing these exit strategies. The timing of the management trades plays a vital role in our success as well as the time value of our option premiums can change as a result of Delta (change in share price) and Theta (passing of calendar days) as demonstrated in this real-life example.
Blue Hour webinars
1- The recording of Blue Hour webinar #3 discussing long-term investing is now available to all active premium members on the member site (left side, scroll down under 10% discount link). The first 2 Blue Hour webinars are also available in that same area.
2- Blue Hour webinar #4 is one you don’t want to miss. I will discuss the “Poor Man’s Covered Call”, a topic many of you have been inquiring about. The strategy uses LEAPS options instead of actual stocks as the underlying security. There will be a lot of new information presented found nowhere else. Look for the event date to be in late January or early February.
Upcoming live events
1- February 27, 2017
Marriott Marquis Hotel, NYC
1:30 PM ET
Exhibit hall Booth 208 (February 26th – 28th) … come say hi to the BCI team
2- March 21st and 22nd, 2017
Two live Florida events (Fort Lauderdale and Delray Beach)
Information to follow
Global stocks edged up slightly after the Federal Open Market Committee’s decision this week to raise the key federal funds target rate by 25 basis points to a range of 0.50% to 0.75%. While the move was expected, markets needed to also digest the FOMC’s statement that it would target three rate hikes in 2017, which was more than expected. The 10-year US Treasury bond yield continued to climb upwards after the FOMC announcement, reaching as high as 2.58% this week, its highest level since September 2014. This week’s reports and international news of importance:
- This week’s FOMC decision to raise the federal funds rate by 25 basis points comes one year after its last hike
- This week’s hike came amid increasing enthusiasm in equity markets, as investors continued to move from defensive positions into riskier segments of the market
- Equity market volatility is much lower and credit and liquidity conditions are also stronger now versus a year ago
- President-elect Donald Trump this week announced his intention to nominate Exxon Mobil chief executive Rex W. Tillerson as secretary of state. The choice of Tillerson’s was criticized by senators on both sides of the aisle, who object his business dealings with Russia and its president, Vladimir Putin
- Trump also announced that former Texas governor Rick Perry is his choice for energy secretary
- The US dollar continued to strengthen this week versus most major currencies
- The Japanese yen has declined 11% since the US presidential election, while the Mexican peso has fallen 10%. China’s yuan has also weakened
- Japan surpassed China as the largest holder of US government bonds this week. China’s government has been selling foreign currency reserves in an effort to protect the yuan
- The US NFIB small-business optimism index rose by 3.5 points in November to 98.4, beating consensus estimates and rising above its 42-year average
THE WEEK AHEAD
- Eurozone wage figures are released on Monday, December 19th
- Japanese trade data and unemployment figures are released on Monday, December 19th
- The Bank of Japan meets to decide monetary policy on Tuesday, December 20th
- Eurozone consumer confidence figures are released on Wednesday, December 21st
- The United States announces estimates for Q3 GDP on Thursday, December 22nd
THE WEEK AHEAD
For the week, the S&P 500 declined by 0.07% for a year-to-date return of +10.47%.
IBD: Market in confirmed uptrend
GMI: 6/6- Buy signal since market close of November 10, 2016
BCI: I am currently fully invested and have an equal number of in-the-money and out-of-the-money strikes. Love the market direction but still feel that a cautious approach is justified.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a bullish outlook. In the past six months, the S&P 500 was up 9% while the VIX (12.20) declined by 36%.
Wishing you the best in investing and a wonderful holiday season,
Alan ([email protected]) and the BCI team