Covered call writing and put-selling generates monthly cash flow because we are selling option contracts and getting paid for undertaking the contract obligations. When a contract is exercised, we then enter another phase where we either buy or sell shares. The purpose of this article is to review and (hopefully) simplify the mathematics of exercise in four scenarios:

  • Buying call options
  • Selling call options
  • Buying put options
  • Selling put options

 

Buying call options

In this scenario, we are paying for the right to buy a stock at the strike price by the expiration date. Since we are paying for this right, we must add the cost of the option to the strike price to determine the actual cost basis of this purchase should we decide to exercise. Let’s set up a hypothetical example:

  • Buy 1 x BCI call $40 strike at $1.00
  • If exercised, we pay $40 + $1 = $41 (our cost basis)

 

Selling call options (covered call writing when buying the underlying shares first)

Here we are selling the right to the option buyer to buy our shares at the strike price by the expiration date. If the option holder chooses to exercise (not our decision), we sell at the strike plus factor in the option premium received. For example:

  • Sell 1 x BCI call $40 strike @ $1
  • If exercised, we receive $40 + $1 = $41 (our sale price)

For call options, we add in the premium to determine our purchase or sale price.

 

Buying put options

In this situation, we are purchasing the right to sell our shares at the strike price by the expiration date. If we decide to exercise, we sell at the strike minus the cost to buy that option. Here’s an example:

  • Buy 1 x BCI put $50 for $1.50
  • If exercised, we sell for $50 less the cost of the option: $50 – $1.50 = $48.50 (our sale price)

 

Selling put options (as when we sell cash-secured puts)

This trade allows the option buyer (not us) the right to sell her shares to us at the strike by the expiration date. For example:

  • Sell 1 x BCI put $50 for $1.50
  • If exercised, we buy the shares for $50 less the premium of $1.50 = $50 – $1.50 = $48.50
  • In my put book, I allude to this as “buying at a discount”

For put options, we subtract the premium to determine our purchase or sale price.

 

Summary

As option sellers we are generating monthly cash flow. When selling call options that are then exercised, our sale price will include both the strike price + the option premium. When selling cash-secured puts which are subsequently exercised, our purchase price is the strike price less the premium received from the put sale.

 

Next live seminar: 

February 28th and March 1st

The International Stock Trader’s Expo: New York City: Marriott Marquis Hotel

 

Saturday February 28th 12 to 12:45 PM

Sunday March 1st 1:30 – 2:30 PM

Both seminars are free to attend.

 

Alan in Orlando at The World Money Show on Friday

covered call writing seminar

Alan’s seminar in Orlando

Market tone
An outstanding jobs report capped a week of mostly positive economic reports:
  • According to the Labor Departmrnt, 257,000 jobs were added to our economy while 235,000 were expected
  • November and December jobs stats were revised higher by a total of 147,000
  • The unemployment rate ticked higher to 5.7% s more people entered the work force
  • Average hourly earnings increased by 0.5% in January to $24.75
  • Personal income in December rose by 0.3% above analysts estimate of 0.2%
  • Both ISM indexes showed expansion as manufacturing came in @ 53.5 and non-manufacturing @ 56.7
  • Business productivity declined by 1.8% in the 4th quarter, worse than anticipated
  • The US trade deficit came in at $46.6 billion larger then expected
  • Construction spending was up 0.4% in December and 2.2% year-over-year
  • Factory orders declined by 3.4% in December

For the week, the S&P 500 rose by 3.0%

 

Summary

IBD: Uptrend under pressure

GMI: 4/6- Buy signal since market close of January 23, 2015

BCI: Cautiously bullish but favoring in-the-money strikes 2-to-1 for new positions as a hedge against recent market volatility

Wishing you the best in investing,

Alan ([email protected])

www.thebluecollarinvestor.com