Covered call writing calculations include initial and final computations. Since our trades incorporate both long stock and short option positions, it can become confusing when determining final capital gains (losses). In July 2019, Ralph shared with me a covered call trade he executed with Guidewire Software, Inc. (NYSE: GWRE). He sold an out-of-the-money (OTM) strike and was evaluating final outcomes under various circumstances.
*** Calculations do not include trading commissions
Ralph’s trade with GWRE
- 7/22/2019: Buy GWRE at $102.22
- 7/22/2019: Sell 1 x $105.00 8/16/2019 call at $1.13
Ralph astutely calculated his final returns as $391.00 if share price moved up to or beyond the $105.00 strike. This included the $113.00 for the option sale and $$278.00 from share appreciation up to the strike price. This represents a 3.8% 1-month return (1.1% + 2.7%). Let’s confirm this by using the multiple tab of the Ellman Calculator:
GWRP Initial Calculations
Final results if share price moves above the $105.00 strike and shares are sold at expiration
In this case, the final returns are the maximum return as established in the initial trade set-up, 3.8% as shown in the screenshot above. Since the stock shares are sold, this return is realized.
Final results if share price moves up to $104.00 and the option expires worthless at expiration
Realized profit on the option side is $113.00. Unrealized profit on the stock side is $178.00. If shares are sold, the stock profit would also be realized.
What if share value moves below the $102.22 purchase price?
The spreadsheet shows the breakeven at $101.09. Overall profit or loss will depend on that threshold.
Discussion
Covered call writing calculations have several components. There are initial and final calculations as well as realized versus unrealized capital gains (losses). The initial trade set-up must incorporate our initial time-value return goal range (2% – 4%, in my case). From there, our positions are managed to ensure the highest possible returns.
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Alan,
Am I diversified? At some point, I am planning on getting into the market. I’m going to sell CSPs and CCs using XLY, XLV, and GLD. I noticed that on days that XLY and XLV are down, GLD is up. (like today) Is there such a thing called “overdiversified”?
Joanna
Joanna,
Using the Select Sector SPDRs is a sound way to achieve diversification. GLD has been a frequent security on our premium ETF reports and has been out-performing the S&P 500 recently.
Rather than be married to those specific Select Sector SPDRs, you may want to include the best-performing when the trades are entered. See the screenshot below for the chart we provided to our premium members this past Wednesday. That chart is updated weekly.
The same holds true for GLD. It’s a solid candidate when it is out-performing the S&P 500 so flexibility and constant bullish re-assessment is critical.
Finally, it is in our best interest to be as diversified as possible while maintaining a personal comfort level with the number of trades we are comfortable managing. For me, it’s 15 – 25 positions (50 – 100 contracts/month).
The Select Sector SPDRs is a great way to diversify with a minimal number of positions.
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Alan
Thanks, Alan….you are always so helpful….I truly appreciate it.
Hi Alan,
I hope all is well. I was hoping to get your thoughts on a trade of mine. In reviewing my trade, I am a bit confused as to what the better course of action was.
I am a bit confused by the math when my stock rises a decent amount. Here’s the trade:
• Buy SEDG for 94.27
• Sell 90 call for 6.30
• Stock moves up to 104.85
• Cost to buy back the option is 14.90
So, if i buy back the option since this is so far in the money, do I lose that initial premium I made when I entered and sold the 90’s? (see screenshot).
I started off ITM and I’m not sure if the results aren’t as strong as if I would have started OTM when looking to unwind when a stock has increased in price.
I have watched your tutorial but just do not have this down yet.
-Mark
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Mark,
This is a successful trade.
The way the trade was set up, our maximum return was 2.3% with a downside protection of 4.5% of that option time-value profit. This return was realized… congratulations.
Now, let’s breakdown the math for the cost-to-close the $90.00 call as expiration approaches:
– The max our shares can be worth is $90.00 due to our contract obligation.
– The option premium to buy-back the $90.00 call is $14.90. This removes the obligation to sell at $90.00 and makes our shares valued at market or $104.85. So, we have a debit of $14.90 and an unrealized credit of $14.85 (realized when shares are sold) , netting a debit of $0.05 or 0.06%. $14.90 looks bad; $0.05 not so much.
Alan
Well it is a tense start to the week with coronavirus fears causing a gap down in the market. My ATM positions are okay at the moment, I can still unwind and roll down to avoid losses if necessary. My plan is to keep a very close eye on things and be ready to adjust if things move down further. If things get worse I’ll be content to roll deep ITM and/or unwind, and consider it a win to simply avoid losses. Granted I’m new to this and have not seen the vix this high so maybe I am overly nervous. How are your positions faring and what is your take?
-Other Steve
Hi Other Steve,
I think most of us who were still holding positions yesterday morning got our heads handed to us on a platter.
Somehow I missed your post yesterday so some of what I am about to say will have the appearance of hindsight. First, don’t panic is usually always a good rule. I say usually always because I wish I had panicked in 2008.:)
What we have mostly seen for the last three years is a fairly quick snap back. The exception was January and September of 2018.September being the worst of the two.
The machines, when faced with news they do not understand reply with SELL, SELL, SELL. Sort of like Jim Cramer on Mad Money.:) Sometimes we will have a follow through the next day but more often than not sell offs like yesterday are a buying opportunity. They will not always be. Certain areas related to the coronavirus may take much longer to recover. Areas like hotels, casinos, amusement parks and places where people gather. Scenes yesterday from large cities in China looked like ghost towns. But here it looked like some opportunities.
I opened some Bull Put Spreads on both SPY and QQQ. Because of the rise in the VIX, reflecting an anticipated rise in volatility, premiums were elevated. Puts premiums normally are higher than calls That’s why I sell them against stocks on which I am bullish or better put, no pun intended, on stocks that are in a bullish trend.
Nothing wrong with being nervous. As Churchill said, “There is nothing like being shot at and missed to focus one’s mind.”
Thanks for posting,
Hoyt
Hi Hoyt,
Thanks for your experienced insights! With the recovery this morning, in hindsight I wish I had taken the opportunity to hit a double. I rolled down one position at closing time yesterday because it had drifted below support and I wanted protection from a potential gap down overnight. This morning it gapped back up so I rolled up to my original strike, losing about .5% of my original return, but I guess it’s better to be safe than sorry. Looks like the virus will be a big consideration when selling our next months positions.
Other Steve
Hi Other Steve,
Yes, it is better to be safe than sorry. We also learn best by doing. What you learned yesterday and today will stay with you for the rest of your trading career.
Remember something else. The stock market is like a bus stop. If the bus pulls away just as you get there just take a deep breath. There will be another bus shortly. If you miss out on a profit or potential profit by not making a trade there will be another opportunity shortly.
Keep moving forward. Keep learning. It will get more comfortable.
Good luck,
Hoyt
Premium Members,
This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor premium member site and is available for download in the “Reports” section. Look for the report dated 01/24/20.
Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the link to the BCI 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
[email protected]
Premium Members,
The email notifying you that the report has been uploaded was resent. The first email didn’t have the login link. However, the second email has the login link.
Sorry for the inconvenience…
Best,
Barry
Alan,
I’ll be in Orlando for the show. I want to shake your hand. I’ve been following you for two years. One of the smartest men in the industry. Your info is so helpful.
Rich
Rich,
I look forward to meeting you in person. Thank you for your generous comments.
Alan
Thank you Alan for all of your work. You have given the community so much and I am eternally grateful.
I have one very brief question if you’d be so kind as to help. In “Covered Call Writing Alternative Strategies” you identify the approximate break even point for the PMCC as:
Long Strike + Net Debit Paid
I know you wrote this book with OTM calls in mind. Is the formula different for ITM PMCC? I personally prefer to write ITM PMCC for the downside protection, so for my preference of strategy would the approximate break even formula be as follows:
Assuming that
Current stock price – ITM strike = inherent premium value
Break even formula:
ITM strike – inherent premium value ?
Thank you for your time.
Best,
Anthony
Anthony,
The formula stays the same. Let’s refer to the Intel example found on pages 121 – 125 of “Covered Call Writing Alternative Strategies”
INTC was priced at $36.73
The $20.00 LEAPS cost $16.90
The OTM $37.50 strike generated $0.66
The BE = $20.00 + $16.90 – $0.66 = $36.24
Now, if we sold the ITM $35.00 call for $2.50:
BE = $20.00 + $16.90 – $2.50 = $34.40
****When we sell an ITM monthly call, we are increasing the chance of assignment or increasing the need for an exit strategy maneuver to keep the trade going. I view the PMCC and Portfolio Overwriting as strategies where OTM short calls are most appropriate because we want to retain the underlyings for the long term. However, if using ITM short calls meets your trading style, trading goal and personal risk-tolerance, then ITM short calls are certainly applicable.
The BCI PMCC Calculator can be used to calculate the BE and other calculations as shown in the screenshot below highlighting the first tab of the calculator.
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Alan
Dear Mr. Ellman,
Thank you very much for your help. I think I’ll book a call with Mr. Bergman in the near future to iron out the kinks in my strategy. I placed an order for a PMCC set up on MU Sunday night and found myself in a bad position at market open due to the gap down. I placed an order to sell the ITM 57 call when MU was at 57.56 only to get filled when MU opened at 55.13! I guess one should wait until after market open before placing orders for this strategy.
Also, can Mr. Bergman assist me in setting up proper PMCP (poor man’s covered puts)? Once the recession hits I’d like to reverse the pmcc strategy by taking deep ITM put positions and selling ATM puts.
Thank you,
Anthony
Anthony,
Lesson learned. The best time to enter a new trade is between 11 AM and 3 PM ET. This allows us to avoid early morning and late afternoon institutional computerized trading and evaluate based on current pricing. A possible exception is when buy/write combination forms are available.
Yes, Barry can assist when you are ready to set up an online mentoring session.
Alan
Hi Alan:
You were kind enough to reach out and respond to some questions I had about your service a few weeks ago. I have done the initial 30 day subscription and I”m impressed with the level of energy and thoroughness you put into your weekly reports.
I do have one question. I am very familiar with put writing and specifically naked put writing. For instance, this past year I tested a system that I created where I sold naked out of the money naked puts after earnings gaps if the stock met certain criteria. I was 62% successful and the size of my winners was almost 2x the size of my losers. My theory was that given certain factors after an earnings gap – not all stocks continued up but a high % of them never came back down.
Anyway, I’ve spent a few weeks trying to understand your system and trying to pull aside some cash from other systems to give your system a run. And I have a question as I know you also wrote a book on selling naked puts. Let’s suppose I’m very bullish on one of the stocks that have met all your criteria, such as RNG. Do you have anywhere on your site material that explains the pros/cons of buying the stock and selling calls vs just selling some puts? I’m curious if you think there are situations when you are selling puts is equally as good or better.
Thanks!
Mike
Mike,
I like selling OTM puts in bear and volatile markets for the additional downside protection prior to entering a covered call trade. I also may use put-selling to “buy a stock at discount” for my buy-and-hold portfolio. In normal to bull market environments,
I prefer covered call writing where we have the ability to use OTM calls and create the potential for 2 income streams (premium + share appreciation). I believe that we can beat the market on a consistent basis with either or both strategies. I’ve attached a comparison chart below which is found in my book, “Selling Cash-Secured Puts”.
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Alan
Hi Alan,
I noticed on the comparison chart where it said “Normally not allowed in IRAs”. While my IRA account allows CSPs and I don’t know about other brokerages with whom I do not have any accounts, I can see why they might not.
The trade itself is “Defined Risk” which qualifies. So it appears that the strike price times the number of shares would be the risk for the trade.
However, it’s possible that an underlying might plunge far below the strike price right after the market closes. Professional traders have 90 minutes after the market closes to close out positions. Unfair? Yes, but that’s the way it is. So if your CSP was the one that was OTM at market close but became deep ITM shortly after the close you could assigned at the strike and the next morning own an underlying, usually a stock, that is worth far less than the strike. In effect your “Defined Risk” was not so defined after all.
I realize this is a rare event, maybe even a black swan, but it happened to me over this last weekend when I thought a put had expired worthless but was assigned, either before or after, the market close and I ended up with an initial $7,000 loss Monday morning. So I know it can happen.
Thanks for all you do. The info from you, Barry and the BCI team is priceless.
Hoyt
Hoyt,
You make a good point. More and more brokerages are allowing cash-secured puts in self-directed IRA accounts. Competition is fierce for our business.
Alan
Hi Dr. Ellman,
I am 22 and a recent college graduate. My uncle told me about your website and I have started studying your books. Since i need to build up some cash first, I started reading your book, Stock Investing for Students. My question is do you still recommend using s&p and total stock market index funds to begin the process. I have about $3,000 to get started.
Thanks a lot,
Bruce
Bruce,
It’s great having you and your uncle part of our BCI community.
Yes, index mutual funds are appropriate vehicles to start building portfolio wealth. Most have microscopic expense ratios (< 0.05%) and a significant majority out-perform average actively-managed mutual funds. We can dollar-cost-average into these funds as shares can be purchased fractionally and dividends re-invested. You're off to a great start to become CEO of your own money and ultimately financially independent. Please keep in touch and let us know how you're progressing. Alan
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.
Also included is the mid-week market tone at the end of the report.
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Alan and the BCI team
Alan,
I wanted to ask how do you manage 20/10 exit buyback? Do you monitor your positions intraday, or, maybe, place GTC orders to close?
Thanks,
Sunny
Sunny,
As soon as my covered call positions are entered, I place BTC limit orders (GTC) based on the 20% guideline. This way, if the threshold is reached, it will be executed even if I am not monitoring my positions at the time. The screenshot below shows 2 such trade executions that hit yesterday when the market dipped early in the day.
I change the 20% threshold to 10% mid-contract (note placed in my calendar as a reminder).
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Alan
Alan,
Visa keeps shows up on the recommend stocks to sell puts.
They are down 3% after the earning calls or 6 points.
Is selling puts on Visa still advised???
When is the next report coming out?
Thanks,
Alp
Alp,
Visa has been so strong for an extended time-frame, that it still may appear on our upcoming watch list. It has made a lot of money for the BCI community. If it does earn its way onto to next watch list, it will be with mixed technicals.
My team starts formulating the new report today after market closes and will post it on the premium member site late Saturday to early Sunday.
Alan
Hope no one has FB.
Another example of avoiding holding during an earnings report.