Covered call writing positions can be altered by exit strategies or contract adjustments. Contract adjustments are alterations that are typically made to option contracts when the underlying stock undergoes a stock split, pays a special cash and/or stock dividend or distribution, or is involved in a merger, acquisition or corporate reorganization. Sometimes they are impacted by both as we take advantage of every possible opportunity to enhance our returns. In this article, I will highlight a real-life trade executed by one of our members, Mike, a few months back. In this series of covered call trades, Mike astutely used the rolling down exit strategy mid-contract and then took advantage of a stock split to continue generating income. The stock Mike used as the underlying security was TRN, a stellar-performer on our “Premium Watch List” and also located in the IBD 50 at that time. The series of trades

  • 5/30/14: Buy 100 x TRN @ $87.43
  • 5/30/14: Sell 1 x $90 call @ $1.20
  • 6/6/14: Share price declines dropping option value to $0.20
  • 6/6/14: BTC (by-to-close) the $90 call @ $0.20
  • 6/9/14: STO (sell-to-open) the$85 call @ $1.00 (may have generated a slightly higher return if implemented on 6/6/14)
  •  6/20/14: Stock splits 2-for-1 doubling the number of shares owned by Mike to 200 and cutting the strike price in half to $42.50
  • 6/20?14: Cost basis cut in half to $43.72
  • 6/20/14: Option expires worthless as TRN closes @ $42.23
  • 6/23/14: STO 2 x July $45 calls @ $0.55
  • 7/11/14: Captures $20 cash dividend for the 2 contracts
  • 7/14/14: At the time I am writing this article, TRN is trading @ $44.95, well above Mike’s cost basis of $43.72 (1/2 of $87.43)

 

Initial calculations

  • Initial return = $120/$8743 = 1.4%
  • Initial upside potential = $257/$8743 = 2.9%
  • Possible 1-month return as trade was set up = 4.3%

 

2-month calculations as of 7/14/14

  • Option credits: $120 + $100 + $110 = $330
  • Option debit = $20
  • Dividend credit = $20
  • Share appreciation: $44.95 – $43.72 = $123/contract = $246
  • 2-month profit as of 7/14/14 = $330 + $246 + $20 – $20 = $576
  • 2-month % return = $576/$8743= 6.6% = 39.5% annualized

 

Descriptive chart showing these trades

 

covered call writing exit strategies and contract adjustments

TRN: rolling down with a stock split

1- Stock purchased @ $87.43 and $90 call sold
2- $90 call bought back
3- $85 call sold (rolled down)
4- Stock splits 2-for-1 and option expires worthless…shares kept
5- Sell 2 contracts of the August $45 calls
6- Dividend distributed
7- Stock trading near $45.95

Summary

To achieve the highest possible level of covered call writing returns we must take advantage of every opportunity that arises during the course of the contract cycle. In this article, I highlighted the execution of the rolling down exit strategy and leveraging contract adjustments to maximize our returns. Understanding that stock splits on uptrending securities is a bullish event that will frequently lead us to favoring out-of-the-money strikes.

Packages that run the Ellman Calculators

With the myriad of devices used these days to download and run software, we are always looking for ways to respond to questions regarding the use of the Ellman Calculators. Here is a file researched and produced by Barry Bergman, the BCI Director of Research, that is now available in the “resources/downloads” section of the premium site and will be available in the “free resources” section of the general site as well:

Packages to run the Ellman Calculators

Packages to run the Ellman Calculators

 

Market tone:

The market seems to have calmed relative to the numerous geo-political events that had it on edge. This week’s reports:

  • Business inventories (a report of the dollar value of product inventories held by manufacturers, wholesalers, and retailers. Included in the report is the inventories/sales ratio, a gauge of the number of months it would take to deplete existing inventories at the current rate of sales, which is an important indicator of the near-term direction of production activity) increased by 0.4% in July, in line with analyst projections
  • Retail sales in July were unchanged from June stats, below analyst expectations
  • Retail sales were up 3.7% year-over-year
  • The Producer Price Index or PPI (a measure of the average change over time in the selling prices of a fixed basket of goods by stage of production, industry, and commodity. It is considered a leading indicator for consumer inflation) was up 0.1% in July, down from 0.4% in June mainly due to a 0.6% decline in energy prices, the largest since November
  • Industrial production (a measure of the changes in quantity of physical materials and items produced in the manufacturing, mining, and utilities industries) rose by 0.4% in July, better than expected

For the week, the S&P 500 rose by 1.2%, for a year-to-date return of 7.1%, including dividends.

Summary:

IBD: Confirmed uptrend

GMI: 4/6- Sell signal since market close on August 4th…nearing a buy signal

BCI: Moderately bullish on the overall economy and moving to a more bullish approach by selling an equal number of in-the-money and out-of-the-money strikes

My best to all,

Alan ([email protected])

www.thebluecollarinvestor.com