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Risky Stocks Can Result in Challenging Decisions

Writing covered calls with high-volatility stocks will result in higher premiums. That’s the good news. These securities may also decline substantially below the strike price and cause option premium to pale in comparison to the share depreciation. That’s the bad news. What if these shares move up exponentially, leaving the strike deep in-the-money and we are faced with the decision whether to close the short call? This is a real possibility especially with high-volatility underlyings. In this article, a real-life example with Axsome Therapeutics, Inc. (NASDAQ: AXSM) will be used to highlight such a scenario.

 

The initial trade

  • 12/2/2019: Buy AXSM at $33.39
  • 12/2/2019: Sell-to-open the 1/17/2020 in-the-money (ITM) $32.50 call for $12.90
  • 12/4/2019: Share price gaps-up to $45.40
  • 12/4/2020: Cost-to-close the $32.50 call is $20.90

 

Initial calculations for the initial trade

AXSM Calculations with the Ellman Calculator

The initial 7-week initial time-value return ROO) is a huge 37% (275% annualized) with 2.7% downside protection of that profit. This immediately flags this stock as highly volatile and risky. Most conservative option-sellers would avoid a security like this one due to the downside risk. This is the most important takeaway of this real-life example but we will go further because this story does, in fact, have a happy outcome.

 

Why did the price gap-up?

One of AXSM’s trial narcolepsy drugs had a favorable Phase 2 result. Share price skyrocketed up by $12.00, leaving the $32.50 strike deep-in-the-money. At this point the maximum return of 37% was looking secured.

 

Should we close the short call?

The cost-to-close was $20.90 with intrinsic-value of $12.90 ($45.40 – $32.50) and time-value of $8.00. This time-value cost-to-close represents about 67% of the initial time-value profit. The exit strategy where we close an entire covered call position early-to-mid-contract is known as the mid-contract unwind exit strategy in our BCI methodology. We move forward when we can generate more than an $8.00 cost-to-close (about 26%). Unless we chance another highly volatile stock, this is unrealistic and so this exit strategy initiation is not indicated at this time.

 

Discussion

Using highly volatile underlying securities is risky and not appropriate for most conservative investors using option-selling strategies. When the implied volatility results in share appreciation, closing the short call depends on the time-value cost-to-close. We use the “Unwind Now” tab of the Elite version of the Ellman Calculator (free to premium members in the resources/downloads” section of the member site) to assist with these decisions. Most of these situations can be avoided by selecting more appropriate stocks based on our personal risk-tolerance. We do so by setting an initial time-value return goal range that protects us against risky trades (2% – 4% per month, for me).

 

To learn more about the mid-contract unwind exit strategy, see the exit strategy chapters in the following books/DVDs:

Complete Encyclopedia for Covered Call Writing- Classic Edition

Complete Encyclopedia for Covered call Writing- Volume 2

Covered Call Writing Online Streaming DVD Program with Downloadable Workbook

 

Your generous testimonials

Over the years, the BCI community has been incredibly gracious by sending our BCI team email testimonials sharing stories as to what our educational content has meant to their families. Moving forward, we have decided to share some of these testimonials in our blog articles. We will never use a last name unless given permission:

Dear Alan,

I learned a lot from your seminar at last month’s Money Show and I have since purchased and read a few of your books. In just 3 weeks of using your strategy to sell both types of options, I have made almost as much as an entire month’s salary ay my regular job. I will be on the lookout for chances to participate in your future online or in-person seminars.

Best wishes to you and keep up the great work!

Matt

Dallas, TX

 

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Trading in a Low Interest-Rate Environment

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Wednesday June 24th

7 PM

Login information to be sent to registered members (club and premium members)

 

2. Greensboro North Carolina AAII Chapter webinar

Covered Call Writing to Generate Monthly Cash-Flow

Option Basics and Practical Application

Saturday June 20, 2020

10 AM

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This presentation will include the basics of trading option, an overview of covered call writing and 4 practical applications of the strategy.

 

Alan speaking at a Money Show event

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Market tone data is now located on page 1 of our premium member stock reports and page 8 of our mid-week ETF reports.

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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.

30 Responses to “Risky Stocks Can Result in Challenging Decisions”

  1. Dave June 13, 2020 3:11 am #

    Hi Alan,

    I’m a student and subscriber and am learning a lot.

    Thursday’s substantial market drop has prompted this question:

    If I have a covered call and the stock price is dropping, at what percent of a drop do you consider closing the position? 1%, 2%, 3%, something else?

    I like your guidance about proactively keeping losses small and preventing more substantial losses by waiting and not acting.

    Thanks for your feedback.

    Dave

    • Alan Ellman June 13, 2020 6:48 am #

      Dave,

      Thursday’s market decline created opportunities to buy-to-close some short calls based on the 10% guideline.

      Yesterday, I placed sell-to-open orders (rolling-down to out-of-the-money strikes) that were filled.

      A reasonable guideline to use regarding selling the stock is when there is a 7% to 8 % price decline from when the trade was executed.

      Alan

  2. Vitale June 13, 2020 6:46 am #

    Dr. Ellman:

    I would like to know how you factor in the risk to reward ratio in your trading system? What ratio do you use? It seems that the R/R ratio should have an impact on stock and option selection. Initially I used a dollar amount as a percentage of my overall portfolio for my stops. Just by default the risk reward would be 1.5 to 2. Risking $2 to make $1.

    I created a spread sheet the other day to document this ratio and I was shocked to see that some of my position that I thought were good trades had a ratio of over 5. Naturally, I quickly adjusted the stop to reflect an acceptable risk/reward ratio. Your thought would be greatly appreciated!!

    Vitale

    • Alan Ellman June 14, 2020 6:48 am #

      Vitale,

      Risk is definitely a factor we should all consider particularly for these low-risk option-selling strategies. We do not want to convert these trading systems to greater exposure than necessary.

      In the BCI methodology, we take the following steps:

      1. Set and define our initial time-value return goal range that aligns with our personal risk-tolerance. I use 2% to 4% in my accounts and 1% to 2% in my mother’s portfolio. Since the time-value return is directly related to the implied volatility of the stock, we manage our initial trade exposure by eliminating securities that are too risky for us.

      2. We utilize the 20%/10% guidelines that assist in defining when to buy back the short call should the underlying decrease in value. We can set buy-to-close limit orders as soon as the initial trades are executed.

      3. A reasonable percentage to use as when to sell the stock after the short call is closed, is 7% – 8% price decline from when the trade was initially executed.

      Alan

  3. Hoyt T June 13, 2020 8:59 am #

    Roni,

    I saw your previous note about selling your company. I can surely relate to how you must feel. It is certainly a bittersweet moment.

    I founded my first company in 1965 on a part-time basis. I went full time in February of 1972. I owned several companies but kept the original until 2012. I sold it as a result of the Great Recession, from which it never fully recovered. It was a tremendous relief and at the same time one of the saddest days of my life.

    The good news is that I have never regretted either starting the business, staying in it for forty years or selling it. In hindsight, which is 20/20 vision, I should have sold it in 2005 when it was at the peak of its value. But life goes on and life is more important that any business. The people with whom I interacted over those years were the best people in the world. Some became, and some still are, my best friends.

    Take care my friend and enjoy the absence of the stress of your business. I wish you and your wife the best.

    God bless,

    Hoyt T

    • Roni June 15, 2020 5:14 pm #

      Hi Hoyt,

      my history is very similar to yours.

      I started this my second and last company in 1984 with $500.00, and my total assets today plus all the expenses I had during these 35 years, came from this enterprise.

      The post subprime debacle resulting recession hit us hard, but we were still in positive territory until 2012 when we had to layoff gradually half of our collaborators. Many had become dear friends.
      In Brazil, labor is lower than in advanced countries, but the charges are very high. Between 80 and 100% of the salaries, depending on the type of job.
      Layoff costs for long time employees are very, very high, and we had to borrow from the bank, to face these extra costs.

      After 2015, the Brazilian economy was hit by several hard blows, and we began to get into negative territory. I started to look for a buyer, which fortunately ended well last week.
      We got a low, but fair price and I am very pleased to hand over the responsibility, especially in this very risky moment.

      I will be 76 years old next month, and still have lots of plans and chores ahead of me for the coming years, plus my work/hobby of trading stocks, and exchanging experiences with the BCI community. 🙂

      Therefore, no regrets – Roni

      • Hoyt T June 15, 2020 6:40 pm #

        Roni,

        Happy Birthday next month. I turned 78 yesterday 6/14.

        Our histories are very similar and we have seen much in our lifetimes. I grew up in a three room house with no electricity or plumbing. Rode to a small town in a mule driven wagon on a dirt road. Hell, I thought everyone lived like that!:) Didn’t feel deprived at all.

        I have twin sons who have been very successful, five grandchildren, two are Doctors, two registered Nurses and one a high school teacher. I am so proud of them all. Best of all they are good people, not greedy or arrogant. I have been truly blessed.

        I wish you every happiness going forward.

        Hoyt

        • Roni June 16, 2020 4:01 pm #

          Happy birthday to you too Hoyt.

          What a wonderful success story.
          In my early years, my parents were immigrants, and I rode my bicycle to school.
          I would like to exchange more details with you, but this blog is not the right place for this.
          Therefore, I will ask Alan to send you my email address, and we can do it privately if you wish.

          Cheers – Roni

          • Hoyt T June 17, 2020 8:09 am
            #

            Roni,

            That would be Great! I would really appreciate that and look forward to hearing from you.

            Jay said for me to give you his regards. You are in both our thoughts.

            Take care,

            Hoyt

          • Roni June 18, 2020 10:46 am
            #

            Thanks,

            say hy to Jay

            Roni

  4. Sunny June 13, 2020 10:50 am #

    Hi Alan,

    I’m paper trading strategy selling CC on best performing Dow 30 stocks and using the cash generated from option premiums to build QQQ position. My question is, when choosing top Dow 30 stocks they must be 3 months outperformers compared to S&P 500, but does these stocks must outperform S&P 500 on 1 year timeframe too? What if stock significantly outperforms S&P 500 on 3 months, but underperforms it on 1 year timeframe? Does such stocks must be eliminated and not used?

    Would be interested to hear your thoughts on this.

    Thanks,
    Sunny

    • Alan Ellman June 15, 2020 7:21 am #

      Sunny,

      Stocks outperforming in the most recent 3-months are strong choices. Of those, the ones also outperforming in a 1-year time-frame are even better as they demonstrate both short-term and longer-term strength.

      So, we have very good and outstanding.

      Alan

  5. Barry B June 13, 2020 9:20 pm #

    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 06/12/20.

    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

    Best,

    Barry and The Blue Collar Investor Team

    [email protected]

  6. Peter June 15, 2020 3:30 am #

    Alan,

    Hope you well safe and healthy and stock market treats you with opportunities.

    I came across a guy who maintains that by trading options he sustainably increases value of high quality stocks.

    What surprised me is that I was certain he would say he is selling options.

    He stated he buys options.

    Are you aware of any options strategy used on rising stocks where buying options almost doubles the gain otherwise earned by stock alone?

    The only way making profit over exiting stocks buying option would then to sale them back capitalizing on time value and value due to stock movements?

    Regards
    Peter

    • Alan Ellman June 15, 2020 7:36 am #

      Peter,

      Call options purchased will benefit from share appreciation in many (but not all) situations. He may be buying call options in addition to buying the shares. These would be 2 separate trades.

      To be successful on the call buy side at contract expiration, he would have to overcome the breakeven point which is (strike + call premium). If a stock is trading at $48.00 and we buy the $50.00 call for $2.00, our breakeven is $52.00.

      During the course of the contract, the option-value will increase (or decrease) by its Delta. It is possible to make money selling that option prior to expiration.

      This approach should be considered of higher risk than our option-selling strategies and may be appropriate for those with a higher risk-tolerance.

      My success has been on the sell side of options.

      Alan

      • Roni June 16, 2020 5:38 pm #

        Alan,

        in your recent post “Buyers have rights, ……..” you stated:

        “Option buyers pay for the right to control shares of stock (or ETFs) at a relatively low cost. If they are directionally correct, there is an opportunity to generate impressive returns on the capital investment. Generally, this is a more aggressive approach to option trading than covered call writing.”

        I do understand the increased risk of such trades, but at the same time, your statement made me think about the opportunities that are created by purchasing options for stocks from the BCI run list, which have been very good choices, and have outperformed consistently the 2% ROO strikes.
        And also considering the low initial cash that is at risk of being lost in such trades.

        As you know, my personal risk tolerance is very low, but I do ask myself if I should be more aggressive, as you say.

        Roni

        • Alan Ellman June 17, 2020 8:56 am #

          Roni,

          There is no right or wrong here. Being on the buy or sell side of options depends on strategy goals and personal risk-tolerance. Most conservative retail investors favor the sell side. That’s where I am.

          Those on the buy side have opportunities to generate substantial returns but at the price of greater capital risk… they can hit grand slam homeruns but also strike out frequently.

          Those of us on the sell side will only hit singles and doubles but will strike out rarely.

          Let’s look at a hypothetical trade where a stock is trading at $48.00 and the price of the $50.00 call is $2.00.

          On the buy side, the breakeven is $52.00; on the sell side the breakeven is $46.00.

          One size does not fit all so we must focus in on our goals and personal risk-tolerance and that will guide us to the strategy approach that best suits our needs.

          Alan

          • Roni June 18, 2020 10:55 am
            #

            Thank you Alan, I understand your explanation, and will give it a lot of thought before deciding.

            Roni

        • Jay June 17, 2020 9:07 pm #

          Hey Roni,

          I enjoyed your and Hoyt’s discussion earlier in the thread. Hope you guys connect in direct e-mail. I have a couple friends through Alan that way, Hoyt being one!

          I think you and Peter are on to something asking about call buying. I do a mix of buying and selling options finding it adds to my toolbox.

          The main advantage on the buy side is the higher profit potential. The main advantage on the sell side is time decay since options are a deteriorating asset.

          When you are ready to experiment I suggest you pick a stock off the list and buy a call. You are absolutely correct it will require far less capital than buying 100 shares of stock. But the clock is ticking against it. The stock will go on. That’s why I almost always pair a bought option with a sold one above it on a call or below it on a put to reduce cost, risk and time decay. It also caps my upside like a covered call does but my cash outlay is even less and my risk is lower in my opinion.

          If you just want to buy a straight out call or put it’s probably best to go out a couple months to not be immediately in the steep part of the theta decay curve unless you are targeting a specific event like an earnings report or Fed meeting you are confident of betting on. Please take profits when you have them. If you buy two contracts you can take one off and let the other run more: “A bird in hand”!

          I can’t remember the last time I held a bought option not part of a spread to expiration or exercised it? The idea is to gain on the option. That’s why early exercise of our sold options is so rare.

          Maybe play with it one contract at a time so you see it versus what the standard buy/write might have done? It’s nice to have both tools at our disposal. Best regards, – Jay

          • Roni June 18, 2020 11:05 am
            #

            Hi Jay,

            good to see you.

            I do believe that personal subjects should be discussed only briefly in this blog. We must stay focused on trading.

            And thank you again for your detailed explanation and great advices.
            It is so helpful to me, especially because I am isolated here in Brazil, where nobody that I know of trades in the USA stock market.

            Roni

  7. Lori June 15, 2020 4:03 am #

    Alan –

    I’m a new premium member. Thank you for presenting the subject matter of options in an easy to understand fashion. I have a question with regard to technical analysis and position management.

    Let’s say that I buy a stock and sell a covered call on a stock that has exhibited all positive parameters, i.e. 20D-EMA over the 100D-EMA with rising MACD and stochastic indicators. Should I consider closing out the position before expiration if any of those indicators turns negative?

    Thank you!
    Lori

    • Alan Ellman June 15, 2020 4:06 pm #

      Lori,

      No. Once a position is entered, it is managed as detailed in the exit strategy sections of my books and DVDs.

      Technical analysis is a critical aspect to our stock selection and position management decisions but does not completely dictate when to close our positions. It is one of several tools we use to enter, manage and exit our trades.

      Alan

      • Lori June 16, 2020 2:49 pm #

        Thank you, Alan, for taking the time to answer. I will review the information on exit strategies in your book, “Complete Encyclopedia for Covered Call Writing.” Have a great day!

  8. Patrick June 15, 2020 1:44 pm #

    Hi Alan,

    This is a quick follow up and thank you from our last correspondence. I should have had a better handle on active management and exit strategies that you always emphasize.

    Just wanted to review a quick option with you. Only if you have time.

    I bought 400 ZYXI @ 18.93 and sold four 6/19 $20 calls at 1.37

    The stock has run in to the money quite a bit. I think buying to close (about 3.70) is a good idea despite the cost as it’s “in the money” value and the stock is up almost 24%. In hindsight I probably should have been looking at a mid-contract unwind. Expiration is only a few days away so I’m guessing buy to close is my best option at this point. Any thoughts you have would be most welcome. Thanks always for your continued guidance. I’m so happy I met you!

    Kind regards,

    Patrick

    • Alan Ellman June 16, 2020 7:43 am #

      Patrick,

      The initial trade structuring showed an initial time-value return (ROO) of 7.2% with an additional 5.6% upside potential for a 1-month potential return of 12.8%. This maximum return appears safe at this point in time… congratulations.

      These returns reflect a stock with high implied volatility and that volatility resulted in a significant increase in share value resulting in a deep ITM $20.00 strike.

      As of premarket this morning (Tuesday), the “ask” to close the $20.00 call will cost $0.48 in time-value or 35% of the original time-value profit or 2.5% in time-value cost-to-close. Can we generate more than 2.5% in the next few trading days? Probably not.

      The time-value cost-to-close will decrease by expiration Friday. In these situations, it generally is in our best interest to consider rolling the option as close to expiration as possible. This gives us additional time to evaluate our choices while still in a great max return situation.

      Alan

  9. Clark June 15, 2020 4:00 pm #

    Hey Alan,

    Do you have a cut off point amount/percentage as to how much a stock has to go down before you decide to cut your losses, buy back the option and sell the underlying?

    Thanks
    Clark

    • Alan Ellman June 16, 2020 7:51 am #

      Clark,

      Since we are in 2 positions with a long stock and short call in place, we must deal with the option side first to avoid dangerous naked option scenarios (most brokers will not allow us to be in these situations).

      We use the 20%/10% guidelines to assist in our timing for closing the short calls. Once closed, we decide on next steps which may or may not be selling the stock.

      A reasonable guideline as when to sell a stock after the short call has been closed, is when price declines 7% – 8% from when the trade was entered.

      We use 7% in our soon-to-be-released BCI Combination Put-Call Calculator.

      Alan

  10. Alan Ellman June 17, 2020 6:39 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.

    Also included is the mid-week market tone at the end of the report.

    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

  11. Nathan June 18, 2020 9:30 am #

    Good morning Alan,

    I love your premium membership! There is so much content.

    I am currently screening the ETF report you provided yesterday for next month’s contracts. From your screening list, I like BOTZ because it has decent technicals (not all positive), good A industry rating, and a 1.34 beta. Based on the technicals though I am not sure if they merit selling out of the money or at them money strike. The price is above the 20 d ema. The STO is moderately bullished based up currently moving up, but is not greater than 80, and the MACD is negative. With the market uptrending and bullish, is this enough to merit an out of the money strike or should I be considering an at the money strike?

    Thank you for your help!

    -Nathan

    • Alan Ellman June 19, 2020 6:39 am #

      Nathan,

      A major factor we consider regarding the “moneyness” of the option is our overall market assessment. If normal-to-bullish, we favor OTM strikes, especially with a bullish price chart. If bearish and or volatile, we favor ITM strikes. I frequently “ladder” strikes using a mix of ITM and OTM strikes.

      Currently, in my humble opinion, we have an accelerating but fragile market. I am favoring OTM strikes 2-to-1 over ITM strikes. On Monday, I will enter new trades and immediately place 20% buy-to-close limit orders to protect against share decline.

      If selling multiple contracts, consider laddering strikes based on market assessment. If selling 1 contract, I tend to favor defensive positions when chart technicals are mixed.

      All strikes, ITM or OTM, must meet our initial time-value return goal range.

      Alan

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