Mastering options calculations is an essential skill needed to attain the very highest covered call writing returns. Although the Ellman Calculator will do most of the heavy lifting for us, understanding the reasons behind these calculations and when and how to apply them, will make us all more skilled investors.
Recently a BCI member sent me a hypothetical trade that involved two of our exit strategy choices: rolling down and the mid-contract unwind exit strategy. Let me first define:
Rolling down: Closing out options at one strike and simultaneously opening another at a lower strike price.
Mid-contract unwind exit strategy (MCU): Closing an entire covered call position mid-contract when the time value of the premium approaches zero and using the cash to establish a second income stream in the same month with a new position.
The hypothetical trade
- Buy shares @ $74.
- STO $74 calls (ATM) @$2.50.
- Buyback $74C’s @0.50.
- Rolldown to $70 strike C’s @$2.
- Price rockets way up to $78.
- Buyback $70C’s @ $8.20
– Now what I want to know is that if I am correct here in knowing that the intrinsic value of the last option (#6) is $8, and T.V is at $0.20(for the $8.20 option), then am I to also take the MCU share gain as $8?(from $70 to $78)
– It can’t surely be from $75 up to $78 can it, as time value would be too large? (or am I wrong?)
– Is my calculation correct for a -$4.20 total options loss, and +$8 for price gain to = +$3.80 profit?
Let’s take off our shoes and socks and do the math
Based on this example I see the confusion commonly experienced by covered call writers. There are 2 sets of calculations that should be viewed individually but frequently are combined and that will cloud the situation. The 1st calculation relates to whether to pull the trigger on the MCU strategy or not. The 2nd is the overall profit (loss) results. Let’s address the MCU 1st:
1- We base our decision whether to completely close our short option and long stock positions based on the current market value of our shares which was rolled down to $70. We do not base it on some value in the past ($74). The time value component to accomplish this is $0.20 because the shares can be sold for $78 and gain $8 in share value at this point in time. If we can generate more than $20/$7000 or .28% (a fraction of 1%) by re-investing that newly-acquired cash, we should pull the trigger on the MCU strategy.
2- Final results: we don’t know yet because the cash generated from instituting the MCU strategy hasn’t been re-invested so the final chapter hasn’t been written. However, to date you have an options debit of:
$2.50 + ($2.00 – $0.50) – $8.20 = (-) 4.20 (sum of all options credits and debits)
You have a share credit of $78 – $74 = + $4 (bought at $74 and sold @ $78)
Total loss to date = (-) $0.20
This tabulates to a fraction of 1% as shown in the figure below:
Mid-contract unwind exit strategy
Now, it’s up to us to write the final chapter that month and re-invest the $7800/contract to turn that small loss into a gain. We turn to our watch list of eligible stocks, find an appropriate price per share and check options chains. The information is fed into the Ellman Calculator as we make our final decisions.
This is a great example of how being active can, in many cases, allow us to manage our positions to mitigate losses, turn losses into gains and enhance gains.
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This week marked another reaffirming an improving economy but with geo-political and global economic concerns:
- 4th quarter GDP was revised upward to 2.6% from 2.4% according to the Commerce Department
- Initial jobless claims for the week ending 3-22-14 came in @ 311,000, less that the projected 325,000
- Consumer spending reached its highest level in 3 years, up 2.2%, according to the Commerce Department
- Sales of new single-family homes dropped by 3.3% in February and 1.1% lower than 1 year ago. This decline was due to rising mortgage rates and severe weather conditions
- Savings rate for February was up 4.3%
- According to the Conference Board, Consumer Confidence rose by 4 points to 82.3, higher then the expected 78.6. This is the highest level in the past 6 years
- New orders for durable goods rose by 2.2% in February after declining the previous 2 months
- Personal consumer spending rose by 0.3% in February more than the 0.2% anticipated
- Personal income rose by 0.3% in February
For the week, the S&P 500 declined by 0.5%, for a year-to-date return of 1%, including dividends.
IBD: Market in correction
BCI: This site continues to be bullish on the economy. It’s difficult to ignore years of improving economic reports. However, because global political and economic concerns we remain slightly bearish in our current holdings, favoring in-the-money strikes 3-to-2.
My best to all,
Alan ([email protected])