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How to Select Replacement Stocks Mid-Contract

Exit strategy management for covered call writing and put-selling is one of the three required skills (stock selection and option selection are the other two) critical to maximizing our returns. A few of the position management opportunities require exiting a position related to a particular security and then locating a new stock to begin another option-selling trade. This article will highlight one way we may choose to use our Premium Stock Report to locate such a replacement stock. I am writing this hypothetical scenario on 12/2/2015 using the most recent Premium Stock Report dated 11/27/2015.

There are many ways to use our reports so keep in m ind that I am presenting just one possible screening process. In this case the investor prioritizes the stock selection as follows:

  • Price per share < $40.00
  • Industry segment rank of “A”
  • Scouter rating (currently available only from The Blue Collar Investor) of “9” or “10”

 

Premium Watch List from 11/27/2015 (partial list to fit this article)

Blue Collar Investor Premium Membership

Premium Watch List from 11/27/2015

 

There are two stocks that meet our initial screening requirements, ATVI and CSFL but note that CSFL does not have adequate option liquidity (“N” in second column from right). Next, let’s check to see our potential returns for the remaining twelve trading days in the December contracts:

Exit strategies for covered call writing

ATVI Options Chain from 12/2/2015

 

Next, let’s feed this information into the multiple tab of the Ellman Calculator to see if any meet our 12-trading day goal:

covered call writing calculations

Ellman Calculator returns for ATVI

 

We find that all four of the selected strikes offer significant initial returns for the remainder of the December contracts. The more bullish we are, the higher the strike we would favor and vice versa.

 

Discussion

Option-selling results are enhanced by being diligent regarding position management. Periodically, we will need to locate a replacement stock which will be aided with a high-quality watch list and a set of screening parameters as well as return goals. Once a system is established, the process becomes second nature to us and time efficient.

 

Live interview

On March 15th at 9 PM ET, I will be interviewed live on blog talk radio (Solutionsology Radio). I will provide the link to this event once I receive it. The focus of the conversation will be about my third book, The Complete Encyclopedia for Covered Call Writing.

 

Just added

April 26, 2016

Options Industry Council Panel Discussion on Income Generation

4:30 – 5:30 PM ET

Link to follow

OIC_Logo

Market tone

Global markets moved up this week in conjunction with a rebound in the financials and energy sectors. The Chicago Board Options Exchange Volatility Index (VIX) fell to 19.5 from 27.5 last week. This weeks reports and other international news of import:

  • Saudi oil minister Ali Ibrahim Al-Naimi said producers will meet in March in hopes of negotiating an output freeze
  • Business confidence in Germany slipped in February, according to the closely watched Ifo business climate index. The index fell to 105.7 from 107.3 in January
  • Several large US banks are increasing loan loss reserves in anticipation of more troubled loans to companies in the oil and gas industry
  • US GDP during the fourth quarter of 2015 was revised upward to 1%, up from the 0.7% initial estimate, but still lower than the 2% pace set during the third quarter
  • For the full year, gross domestic product rose 2.4%, matching 2014’s growth rate
  • The Shanghai Composite Index dropped by 6.4% on Thursday, but global markets did not follow its lead
  • US Federal Reserve Vice Chair Stanley Fischer said it is too early to assess the impact of recent market volatility on the US economy.
  • Credit rating agency Moody’s this week cut Brazil’s sovereign credit rating to Ba2, a two-notch downgrade. All three major agencies now rate Brazil below investment-grade.
  • After slumping sharply in December, US durable goods orders bounced back in January, rising 4.9%
  • Nondefense capital goods orders excluding aircraft, a proxy for capital spending by companies, rose an impressive 3.9%
  • Consumer prices in the eurozone rose a scant 0.3% on an annualized basis in January. This will keep pressure on the European Central Bank to add additional monetary policy stimulus at its policy-setting meeting in March

For the week, the S&P 500 increased by 1.58% for a year-to-date return of  (-)4.69%.

Summary

IBD: Market in confirmed uptrend

GMI: 3/6- Sell signal since market close of December 10, 2015

BCI:  I will remain focused primarily in defensive positions, selling out-of-the-money puts and in-the-money calls in a ratio of 3-to-1 over more aggressive positions.

Wishing you the best in investing,

Alan ([email protected])

 

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

25 Responses to “How to Select Replacement Stocks Mid-Contract”

  1. February 27, 2016 1:57 am #

    Alan,

    I have been using your system now for about 2 years and even in the difficult last months it to my surprise and pleasure keeps functioning. I own and have read all your books and use covered calls and cash covered puts. The only thing I cannot seem to find an answer on is what percentage of the portfolio you should make a trade. To small and I run out of trades to big and I take to much risk is there a general percentage for trades in bigger
    let’s say over 250000 dollar portfolios?Thanks in advance for your time.

    Thanks,
    Johanna

    • February 27, 2016 10:04 am #

      Johanna,

      For larger accounts we must first determine the number of positions we are comfortable managing. Is it 10, 15, 20? Let’s use 10 stocks in a portfolio funded with $250,000. That averages to $25,000 per position. Next divide the price-per-share into $25k and round to the nearest 100…that’s how many shares we buy of that stock and then repeat for the other 9 making sure there is 2-4% of your total cash value left in cash for potential exit strategy executions.

      That formula will make sure we are staying within our comfort level as well as keeping to the BCI requirement of equal cash allocation per position.

      Alan

  2. February 27, 2016 8:54 am #

    Hi Alan,

    Quick question around the Bid/Ask and the spread. I’m getting confused on how the market maker works. When I initially looked at a stock this morning it had a wide spread. 3.20 Bid and 4.80 ask. The Bid size was 93 and ask size was 91. The returns at the bid were small, but with such a large spread I figured I could buy the stock and sell a 3.70 or higher OTM call option (the last was 3.80). I purchase the stock and put a market call order for 4.00 dollars, well below the 4.80 ask size currently with 91 “asks”. Once my order gets processed I see my screen update to “1 ask” at 4.00. Upon seeing that I felt like I was tricked. How was it just a 91 ask and as soon as my order goes through it’s 1 ask at my price? How are we supposed to play the bid ask spread if it changes like that?

    Upon seeing that information I updated my order to sell the OTM option at 3.70. That was accepted and still netted me a 2.4% return with 11% downside. However I was hoping for a 4% or better trade. Also As soon as my 3.70 was accepted. The bid ask spread reverted back to 3.20 bid and 4.30 ask with 91 and 93 for the bid and ask size. Very confusing. Thanks for all you do.

    Bill R

    • February 27, 2016 9:05 am #

      Bill,

      Good job leveraging the “Show or Fill rule” to generate higher returns. The SEC requires market-makers to publish bid offers that improve the market as your $4 bid offer did IF they do not execute the trade. That, in turn, decreased the spread. When you changed the bid offer, it was a price the MM could live with and the spread reverted back to the original amount. This was a “win-win” because you received a price $0.50 higher than the published bid and the MM was able to retain the large spread. Generally, I would favor options with tighter spreads whenever possible.

      Keep up the good work.

      Alan

  3. February 27, 2016 2:39 pm #

    Alan,

    Is it better to sell my stocks after a expiration but right before the earning announcement?

    I am thinking of saving the portfolio value if bad earnings are reported.

    Thanks.

    Anthony

    • February 27, 2016 2:45 pm #

      Anthony,

      Avoiding earnings reports is a key rule in the BCI methodology. If a strike is in-the-money, I will allow assignment if there is earnings due out in next contract month. If the strike is out-of-the-money, I will usually sell the stock prior to earnings with rare exceptions when I hold the stock through the report and then sell the call. I did that years ago with Cisco and Apple which at the time were consistently positively surprising.

      Another approach, if the stock has Weeklys, is to sell Weeklys up to earnings week , skip earnings week, and resume selling calls the following week.

      Bottom line…I rarely own a stock in my covered call portfolios that are reporting earnings prior to contract expiration for the very reason you stated in your question.

      Alan

      • March 8, 2016 6:34 pm #

        Have you tried buying a protective put during earnings reports?

        • March 8, 2016 8:02 pm #

          Alex,

          This would prevent catastrophic loss but we would still be susceptible to share price decline from current market value to the put strike if the report disappoints. Also, because of the high implied volatility prior to an earnings announcement the cost of the put would be high. This is better than not protecting the downside but why not stay on the sidelines with this stock until after the report?

          Alan

  4. February 27, 2016 7:56 pm #

    BCI Friends,

    Trying to do anything in this marke recently brings to mind my favorite passage from my favorite author F. Scott Fitzgerald:

    “I must hold in balance the sense of the futility of effort and the sense of the necessity to struggle; the conviction of the inevitability of failure and still the determination to ‘succeed’-and, more than these, the contradiction between the dead hand of the past and the high intentions of the future.”

    Fortunately we options sellers have brighter dispositions knowing our premium received is never the problem. It is the dastardly stock or index that lies beneath it :)! Every long investor carries that cross. We just get more help…

    Where does the market go this week? I certainly do not know but predict higher with Spring seasonality.

    The last line of my Fitzgerald quote (from “The Crack Up”) is:

    “If I could do this through the common ills-domestic, professional and personal-then the ego would continue as an arrow shot from nothingness to nothingness with such force that only gravity would bring it to earth at last.”

    Please have a system in your trading so ego never controls your mouse or keyboard :). – Jay

  5. February 28, 2016 1:22 am #

    Premium Members,

    This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor Premium Member website and is available for download in the “Reports” section. Look for the report dated 02/26/16.

    Be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar Investor YouTube Channel. For your convenience, the link to The Blue Collar Investor YouTube Channel is:

    http://www.youtube.com/user/BlueCollarInvestor

    Since we are in “Earnings Season”, be sure to read Alan’s article, “Constructing Your Covered Call Portfolio During Earnings Season”. You can access it at:

    https://www.thebluecollarinvestor.com/constructing-your-covered-call-portfolio-during-earnings season/

    Best,

    Barry and The Blue Collar Investor Team

  6. February 28, 2016 2:16 pm #

    Alan,

    I am doing primarily weeklies and am wondering if you think there is a benefit to selling on Friday vs Monday. It would be preferable to wait for your new weekly report on Sunday before selling for the week but I don’t want to lose 3 days out of 7 time value.

    Thanks,

    Earl

    • February 29, 2016 3:20 pm #

      Earl,

      I have spoken with several market makers about this subject and the consensus I have received is that Theta is calculated on Friday for the entire weekend rather then evenly divided over Friday-Saturday-Sunday. This means that if we sold our options on Friday, we would be getting little or no time value benefit while incurring the added risk over the weekend. I prefer Monday.

      Alan

  7. February 28, 2016 10:00 pm #

    Premium Members,

    The Premium Member Weekly Report has been revised and uploaded to the Premium Member website. There was a typo in the ER date for SWHC. It was reported as 03/08/16…the actual date is 03/03/16 (confirmed on Earnings Whispers and the CBOE websites). Look for the report dated 02/26/16-RevA.

    Best,

    Barry and The Blue Collar Investor Team

  8. February 29, 2016 2:42 pm #

    Alan,

    I have just joined the BCI community and appreciate the great educational products.

    One Question: Do you set a stop or trailing stop on the covered stock to minimise a disaster or buy put protection? If so at what percentage or is it based around previous support levels?

    Best Regards,

    John

    Melbourne, Australia

    • March 1, 2016 3:12 pm #

      John,

      Since we are in a short options position protected by the long stock position, our initial focus should be on buying back the call if share price declines. For that, we use the 20%/10% guidelines. Once the short position is closed, we can make our decision as to whether to sell the stock, take no initial action or write a different call. Protective puts will prevent catastrophic share loss but will impact our premium profits. There are pros and cons to protective puts. For those who want to use a percentage price decline when selling the stock, an 8-10% range is reasonable. Details on exit strategy techniques are found in pages 245 -302 of the Complete Encyclopedia-Classic version and pages 243 – 272 of the Complete Encyclopedia volume 2.

      Alan

  9. February 29, 2016 3:03 pm #

    Alan,
    Lets say I m in a short position on XYZ stock at 3.85, now trading at 4.7. I want to sell puts at 4 strike price with March expiration, after collecting premium my B/E will be around 4.10
    and say stock drops below 4 before expiration, would I still be able to keep the same premium when I sold the puts?
    And if stock is below 4 , it would still be exercised/bought back at 4..right?

    thanks

    Naeem

  10. March 1, 2016 3:36 pm #

    Naeem,

    Yes, the put premium is yours to keep and the shares will be put to you if the strike is in-the-money (higher then stock price) at expiration.

    Alan

  11. March 1, 2016 4:27 pm #

    Alan,

    I am new to BCI and have placed the following trades on TSLA after having read your books, taking the beginners courses, and reviewing the “Ask Alan” questions. I have been successful on other covered call trades, but this one, not so much. My intention was to generate additional income using covered calls on my existing TSLA position. These are the trades I placed:
    12/1/16 – Buy 100 Shares TSLA @ 234.98
    12/23/16 – STO 1/15 $240 @ 6.20 – (Expired)
    2/2/16 – STO 2/19/16 $200 @ 5.85
    2/12/16 – BTC 2/19/16 $200 @ .05
    2/12/16 – STO 3/18/16 $155 @ 8.60

    The stock is now trading at $191.10 and I’m not sure what to do. Can you advise me on the best way to get out of this with the least amount of loss?

    Any advice would be appreciated.

    Paulette

    • March 1, 2016 4:47 pm #

      Paulette,

      I am a firm believer that every trade can be a positive experience for us. Winning trades because of the cash it puts in our pockets and losing trades because of the lessons we will learn and mistakes we will not repeat. Let’s review the chart I created below:

      1- Buy shares
      2- Sell 1st option
      3- Sell 2nd option
      4-Close 2nd option and sell 3rd option
      5- Shares currently trading above $180

      Some points to evaluate:

      1- Why not sell the December Monthly?
      2- 2/10 earnings report should be avoided
      3- The elephant in the room: Why hold a stock in the yellow shaded area?

      One of the mistakes I made early on and most retail investors make is to feel we’re married to a stock once we buy it. We are not. It’s the cash we care about, not the stock. Exiting a long stock position after closing the short call on a stock declining precipitously and under-performing the market is something we should all feel comfortable executing. We take the cash and move on to another, better-performer.

      At this point, it looks like you will lose $59.38 per share because the option will be exercised at the $155 strike unless there is major share collapse.

      Studying losses can be valuable lessons and put cash in our pockets moving forward.

      CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.

      Alan

    • March 2, 2016 10:23 pm #

      Paulette,

      Thank you for sharing your TSLA trade with us. We all have our “TSLA’s” to confess!

      It’s always about the stocks or ETF’s we choose and the direction we bet on. Never the options we sell.

      Sold options will compliment or agitate. Never compensate. – Jay

  12. March 2, 2016 5:24 pm #

    Premium members:

    This week’s 8-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site. The report also lists Top-performing ETFs with Weekly options as well as the implied volatility of all eligible candidates. For your convenience, here is the link to login to the premium site:

    https://www.thebluecollarinvestor.com/member/login.php

    NOT A PREMIUM MEMBER? Check out this link:

    https://www.thebluecollarinvestor.com/membership.shtml

    Alan and the BCI team

  13. March 3, 2016 11:04 am #

    Hi Alan,

    I started to read the book and I found difficult to understand the concept of selling in the money calls.

    Why would I do that? Knowing it will be assigned immediately, or it’s not?

    From the buyer perspective probably the premium is just the same as buying the shares in the market, am I right on this assertion?

    Maybe it will be explained in subsequent chapters in the book and I am just jumping the gun.

    In any case I appreciate your help with this.

    Regards

    Alex

    • March 3, 2016 3:36 pm #

      Alex,

      It is critical to master how and when to use in-the-money strikes. These strikes will rarely be exercised early so we have until 4 PM ET on expiration Friday to avoid assignment if that is the path we decide on.

      Only in-the-money strikes have an intrinsic value component. This IV serves as protection of the time value component. It’s a free insurance policy. Out-of-the-money strikes offer all time value and the opportunity for additional share appreciation from current market value up to the strike. We favor OTM strikes in bull market environments and ITM strikes in bear and volatile markets. Look for the sections involving strike price selection in my books and DVDs for more details with specific examples.

      Alan

  14. March 4, 2016 2:15 pm #

    My stock has gone up about 10%, still shows bullish trend. Does it make sense to sell a Covered call or just sell the stock?

    Giri

    • March 4, 2016 2:19 pm #

      Giri,

      There is not enough information in your question to make a meaningful assessment. It would depend on how fast the price increased by 10% and what our overall market assessment is. Generally, a 10% price increase is a positive and if concerned about the overall market, we can write an in-the-money strike for additional protection.

      Alan

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