To maximize our covered call writing profits it is critical to take advantage of our exit strategy opportunities. Last week I posted a few comments regarding the mid-contract unwind exit strategy and received several emails asking for more information about the trade I alluded to. In this week’s article I will walk through the steps of this trade and exit strategy execution as well as the thought processes behind them.
The original trade:
Buy 300 TPX @ $73.73
Sell 3 x March $70 ITM (in-the-money) calls @ $5.82
ROO (initial profit/contract) = $5.82 – $3.73 (intrinsic value) x 100 shares / $70 (“bought down” cost basis) x 100 = 3%
We use ITM strikes when we want to secure downside protection of the initial option profit. It is a conservative approach to covered call writing.
Preparation for the “mid-contract unwind” exit strategy opportunity:
Like a good boyscout BCIs are always prepared to take advantage of a cash-generating opportunity. In this case we are looking for share appreciation to the point where the option premium is trading near parity or almost all intrinsic value. Whatever time value component is still remaining for this option premium will be a debit in our account if we close the short call position. If we close with a small debit and can generate a much larger credit, it’s time to act.
The end of week 1 for the March contracts:
February 23rd: I noticed that many of our premium watch list stocks had been strong with significant price appreciation including TPX. I posted on this blog to keep an eye out for these exit strategy opportunities.
February 24th: TPX was up another $1 in early trading to $78.05. I pulled up the options chain and found the $70 call trading @ $8.40, $0.35 above parity ($8.40 – $8.05). This represented a debit of 0.5% or one half of one percent. With more than 3 weeks remaining until expiration Friday I knew that generating a credit significantly more than 0.5% would be an easy task. Here’s what unwinding this covered call position looked like (if not using a buy-write combination form, always close the short call first):
BTC (buy to close) 3 x March $70 calls @ $8.40
Sell 300 x TPX @ $78.05
The true value of our shares was $70 due to our option obligation. By removing the obligation, we sold for $78.05 cancelling out all but $0.35 of the cost to close. Now my account had $21,000 to open a new covered call position in the SAME month with the SAME cash.
Selecting a new covered call position- The Premium Watch List:
I will oftentimes get the question as to why our team screens stocks each week when we are selling 1-month options. This is a great example as to why. It is essential for our members to have the most up-to-date information when executing these mid-contract trades. General members must also update your watch lists on a weekly basis to maximize the cash returns building up in your accounts. Based on our portfolio needs (diversification etc.) and our risk tolerance (beta of stock) as well as our income return goals for the 3-week period we make several selections and gather the information needed to enter into the Ellman Calculator. I have selected three stocks that would meet my return goals for consideration:
The Ellman Calculator- Multiple Tab:
I filled in the ” blue cells” with information obtained from the option chains and the resulting calculations are in the “white cells ” (now colorized) on the right side of the spreadsheet:
The three stocks I alluded to are located in the red rectangle. Please note the following:
Yellow column: ROO: Initial returns are all well above the 0.5% debit I incurred closing my position.
Green column: Upside potential for out-of-the-money strikes. If you are bullish you can select the $40 call for EXXI (for example) where you will generate a 2.3% initial return with another possible 3.3% for share appreciation creating a potential 5.6%, 3-week return. This does not include the initial 3% return (less the 0.5% to close the original position) that this same cash generated with TPX.
Purple column: Downside protection of the option premium (time value only). If you are cautious in your approach or have a low risk-tolerance you may opt for the $37 call for EXXI or the $37.50 call for SWI both of which offer > 2%, 3-week return with > 4% protection of those profits.
How many shares should I buy?
The cash generated into my account was $21,000 which will allow me to buy 500 shares of SWI or EXXI and just under 400 shares of RAX ( I would have to add about $500 to buy 400 shares).
Which stock and strike price should I select?
It is up to each individual to decide which stock and strike is best for your portfolio. I am a conservative investor and would lean to an ITM strike to garner the additional protection. Keep in mind that the cash invested in this 1-month has already generated a 3% return for the first covered call position (TPX) and now another > 2% return (you will see an ADDITIONAL $400 + in your brokerage accounts for your effort) for a 1-month total of > 5%. A 10-year treasury bond generates 2% annually.
As an aside:
I also sold several March $75 calls for TPX but as I am writing this article the $75 call has $1.35 of time value or 1.8%. This is far from “parity” and I am not willing to unwind at that cost.
To maximize our covered call returns we must be prepared to take advantage of our exit strategy opportunities. Don’t let them pass you by. Initially, members new to this strategy may be intimidated by the process. I know this because I was feeling these same sentiments when I started teaching myself this strategy. After a while it will become second nature and all that extra cash will make the learning curve time well spent.
Seminar in Atlanta:
I was invited to speak before the American Association of Individual Investors Atlanta Chapter on Saturday April 14th from 10 AM to 1PM. This presentation is open to non-members as well . The venue is Cobb Galleria Centre which is Atlanta’s premier Convention Centre. I will be providing a link to register once the event is posted on the AAII site.
This past week continued to re-enforce our positive market and economic outlook. Along with encouraging reports regarding Greek debt negotiations were the following reports:
- New home sales in January were down 0.9% due to an upward revision of December stats. January sales were actually up an encouraging 3.5% compared to a year earlier
- Existing-home sales rose by 4.3% in January
- Inventory of unsold homes decreased to 6.1 months, the lowest level since 2006
- Initial jobless claims came in at 351,000, lower than expected
For the week, the S&P 500 rose by 0.3% for a year-to-date return of 8.9% including dividends.
IBD: Confirmed uptrend.
BCI: Moderately bullish selling an equal number of ITM and OTM strikes.
Thanks for all your support.
My best to all,