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Rolling Out Decisions: Evaluating a Real Life Trade

Rolling options is an important exit strategy choice when selling covered call and put options. Options can be rolled up and down in the same contract month or a future contract month. For the most part, we roll down in the same contract month and roll out or out-and-up in the next contract month.  I recently wrote an article evaluating a trade executed by one of our members where an option was rolled up in the same contract month, an approach I rarely subscribe to. In this article we will evaluate another real-life trade by one of our members (we have a great group!) where an option was rolled out. The two-month results were positive but could they have been better?

 

The initial trade with VRX: Month 1:

  • 5/26/2015: Buy 100 VRX at $234.60
  • 5/26/2015: Sell 1 x June $240.00 call at $4.50
  • 6/17/15: Early on expiration Friday the stock was still trading near $234.60

Let’s feed this preliminary information into the multiple tab of the Ellman Calculator:

calculating covered call writing returns

VRX- Initial Calculations

 

We see a respectable 1.9% initial return with the possibility of an additional 2.3% from share appreciation. Because share price remained stagnant, the actual one-month return was 1.9% or 23% annualized. Very nice so far.

 

The second trade with VRX: Month 2:

The option was rolled out to the next month $240 strike. This involved closing the June $240.00 contract (BTC) and opening the July $240.00 contract (STO). The option credit for these trades netted $0.20. Then, mid-contract, the option was rolled down to the $235.00 strike. Here are the trades in month 2:

  • 6/17/2015: Rollout to the July $240.00 strike for a net credit of $20.00 for the contract
  • 7/8/2015: BTC (buy-to-close) the July $240.00 call at $2.35
  • 7/9/2015: STO (sell-to-open) the July $235.00 call at $4.50
  • 7/17/2015: VRX was trading at $240.00 level and shares were sold at $235.00

 

Calculating 2-month returns

The shares were purchased at $234.60 and sold for $235.00, a net credit of $40.00 for the 100 shares (less small trading commissions). There were option credits of $450.00 + $20.00 (includes rolling option debit) + $450.00 = $920.00. There was an option debit of $235.00. The net option credit was $685.00. The total position credit was $685.00 + $40.00 = $725.00 which calculates to a 2-month return of 3.1% on a cost basis of $23,460.00. This annualizes to 18.5%. On the surface this looks pretty good especially when we compare it to other investment choices we have these days.

 

Could the trade have been improved?

As Blue Collar Investors, we are always looking for ways to elevate our returns, even good ones, to higher levels. A 3.1% 2-month return appears reasonable on the surface but of that total, 1.9% was generated in month 1. The remaining 1% was generated in month 2 so therein lies the weakness of this 2-month trade. It seems that the option from month 1 was rolled when there was no need to do so. The share price was much less than the strike ($240.00) and so allowing the option to expire worthless was the prudent thing to do (take no action). That would eliminate any time value spent to close the near-month option plus eliminate one commission. Since the shares would not be sold, the next month option could be sold on Monday. Let’s make the reasonable assumption that the time value remaining on the near month option was $0.10 and so the next month $240.00 strike sold for $0.30, leaving a net credit of $0.20. Even if the option wasn’t rolled the initial return of the next month option ($0.30 is our educated assumption) only generated 0.12% initial profit, far too little.

 

How to improve this 2-month trade

  • First, don’t roll the option
  • Sell a lower strike if VRX was still maintained as an underlying security, probably the $235.00 strike which was used late in the contract
  • Using the $235.00 strike would have generated a significantly higher time value return especially if it was used early in the contract. It is reasonable to assume the return would be greater than the $4.50 originally generated in the near month trade (which had a higher strike of $240.00).
  • If the calculations for VRX did not meet our goals, sell the stock and use a different security

 

Discussion

Exit strategies like rolling options are absolutely critical to maximizing covered call returns. There are times when these strategies should and should not be used. Setting goals for initial monthly returns is one way we are guided to proper decisions. For example, if a trader sets a goals range for monthly returns of 2-4% as I do, a rolling return of 0.12% would never be given consideration. That said, the trade was an overall success and I commend our member for the way it was managed. Now let’s take that 18% annualized return and bump it up even higher.

 

Next live appearances

1- St. Louis, Missouri

September 15, 2015

6:30 PM – 9 PM

Link to register

 

2- All Stars of Option Trading

September 16, 2015

Discussion panel

New York Stock Exchange

4:20 PM – 5:15 PM

 

Market tone

Financial markets took a breather from recent volatility, and global stocks generally rebounded after a run of daily losses ended Monday. US data releases were mixed. This week’s economic reports:

  • US GDP grew at an annualized pace of 2.3% in the second quarter, below the median economist forecast of 2.6%. First-quarter GDP was revised up to 0.6% growth from the 0.2% contraction reported previously. Growth was the result of an increase consumer spending and strengthening labor and housing markets
  • The Fed’s two-day July meeting ended Wednesday with no policy action and only minor changes in the post-meeting statement
  • The employment cost index rose a seasonally adjusted 0.2% in the second quarter, the smallest quarterly gain since recordkeeping began in 1982. Sluggish wage growth could cause the Fed to wait longer before raising interest rates
  • US home prices continued to rise but pending home sales fell and the home ownership rate sank to a 48-year low
  • The S&P/Case-Shiller Home Price Index rose 4.4% in the 12 months ended in May, up from 4.3% in April
  • Pending home sales declined 1.8% in June after five straight monthly increases
  • The home ownership rate dropped to 63.5% in the second quarter, the lowest since 1967
  • US nondefense capital goods excluding aircraft, a key proxy for business spending plans, increased 0.9% in June after falling 0.4% in May
  • Overall durable goods orders rose 3.4%, driven by an 8.9% jump in orders for transportation equipment
  • The University of Michigan consumer sentiment index fell to 93.1 for the final July reading down from 96.1 in June and below the median economist forecast of 94.0
  • The Conference Board’s index of consumer confidence dropped to 90.9 in July from a downwardly revised 99.8 in June. The current reading is the lowest since September 2014, and the monthly decline was the steepest since August 2011
  • Initial US jobless claims rose 12,000 to 267,000 for the week ended July 25th
  • Continuing claims climbed 46,000 to 2.26 million for the week ended July 18th

For the week, the S&P 500 rose by 1.16% for a year-to-date return of 2.18%.

Summary

IBD: Uptrend under pressure

GMI: 5/6- Buy signal

BCI: Cautiously bullish using an equal number of in-the-money and out-of-the-money strikes.The Fed watch continues with a probable rate hike of 25 basis points in September or December. When it occurs, it may temporarily spook the market.

Wishing you the best in investing,

Alan (alan@thebluecollarinvestor.com)

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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.

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18 Responses to “Rolling Out Decisions: Evaluating a Real Life Trade”

  1. Barry B August 1, 2015 4:06 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 inthe “Reports” section. Look for the report dated 07/31/15.

    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 BCI Team

  2. Roni August 1, 2015 7:48 pm #

    I agree, and would like to add :

    If you still love VRX, early on expiration friday 06/17/15 there is little chance for VRX to top $240.00, and if it does, you will make an extra 2.3% gain ($540.00), and your total one month gain would be 4.3% (990.00) = 52% annual.
    So no risk at all to do nothing, and let the option expire worthless or be exercised.

    Rolling out for $20.00 barely covers the comission, so it really does not make sense. If VRX goes down, you have no protection, and if it goes up, you are limited to $240.00.

    • Alan Ellman August 2, 2015 6:52 am #

      Roni brings out a great point that measuring risk versus reward will guide us in making appropriate investment decisions for our personal risk tolerance. Higher risk with little reward is not the Blue Collar way as Roni points out.

      Alan

    • Jay August 3, 2015 3:34 pm #

      Hey Roni,

      Thanks for your always insightful post.

      Your mention of VRX got me thinking about how my approach to covered call writing has evolved – or at least changed – over the years.

      When I started I sought the Holy Grail of 2-4% a month on every position. I soon discovered that was not realistic since the market is a three dimensional beast moving up, down and sideways.

      I also learned some stocks need more help than others. My high fliers like VRX were encumbered by calls and I tended to under perform their total return scrambling with exit strategies and buy backs while I out performed my less sexy stocks when I added covered calls.

      So I switched Grails. I now want to match or outperform my stocks total return using covered calls.

      Soon after feeling confident in Alan’s methods it struck my how flexible they are.

      I split my stocks into 3 camps: hi-growth, growth and stable. I do not write calls on hi-growth like VRX unless I am bearish for the month as I am for August and September. I found I can not keep up with my race ponies writing calls so I let them run.

      I write against half my growth stock shares each month. These are the APPL, NKE, DIS variety. Great stocks but unlikely to go parabolic.

      I write against all my stable stocks each month regardless of dividends: MSFT, KR, PKG, PFE and that ilk.

      Anyway, Roni, thanks for getting my conversational juices flowing on a topic we all love. – Jay

      • Roni August 8, 2015 5:55 pm #

        Hello Jay,
        sorry for delayed response. I bought a new computer and missed some online time.
        My new beast is a rocket !!! Really great.

        You are right about separating hi-growth, growth, and stable stocks. It is certainly more lucrative.

        My problem is that I’m chicken, soooo…. chicken.
        Therefore, I follow Alans method by the rules, and never regret missed gains.
        When a stock I hold goes parabolic before expiration, I feel good and assured that my trade will succeed.
        When it is called away, I remove it from my watch list, and never check it out until it shows up again on the BCI weekly stock screen.

        All my positions are protected by covered calls to minimize losses when a stock goes down.

        It’s always fun, just the same. – Roni

  3. Robert August 2, 2015 6:47 am #

    Alan,

    I am a 40+ year investor, but have only recently begun to explore options. Another issue I have run into is that brokers seem reluctant to grant authority to sell puts. Do you have any advice on how to overcome this?

    I appreciate your site, and will undoubtedly subscribe.

    Thank you,
    Robert

    • Alan Ellman August 2, 2015 7:14 am #

      Robert,

      Brokerages determine their specific requirements for levels of trading approval based on decisions made by their legal and compliance departments. They have become quite sensitive to the SEC regulations that require them to “Know Your Customer”

      Most consider covered call writing the lowest level of trading approval for options and retail investors so it may be best to start there. Although put-selling is quite similar to covered call writing, there are differences and brokerages consider put-selling to be less intuitive for retail investors than covered call writing. Your trading experience, portfolio size and investment goals also play a role.

      Alan

      • Nate August 4, 2015 6:46 pm #

        Robert,
        One thing you may need to consider when requesting put selling is to consider if it is cash secured or not. A cash secured put is generally option allowance level 2 and naked puts are level 6. Much easier time getting approval on cash-secured puts.

        Also you can count your paper trading as “option experience.”

        Nate

        • Alan Ellman August 5, 2015 11:02 am #

          Notice how Nate correctly used the term “cash-secured puts” when requesting a level of trading approval. Some investors confuse the term “covered puts” which involves selling a put as well as short-selling a stock…a different strategy entirely. Check out this article:

          https://www.thebluecollarinvestor.com/covered-puts-versus-covered-calls/

          Alan

  4. Alan Ellman August 3, 2015 11:09 am #

    Running List stocks in the news: LAD:

    Lithia Motors has been a member of our elite Premium Watch List for over five months. This company operates 129 auto dealerships in fourteen states. Lithia has boasted three earnings “beats” in the last quarter averaging an impressive positive surprise of 15%

    2nd quarter-over-quarter same store sales was up 11%. Service and parts sales rose by 10%.

    Our Premium Watch List shows LAD part of the “Retail” industry segment, currently ranked “C”, a Scouter Rating of 10, a beta of 1.48, a % dividend yield of 0.70 and an ex-dividend date of 8/5/2015.

    The chart below is what they mean when they say “a picture is worth a thousand words”

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

    Alan

  5. Roseann August 4, 2015 12:05 pm #

    Alan,

    What do you think of index options. Are they riskier than stock options? I don’t think you’ve ever mentioned index options.

    Thanks.
    Roseann

    • Alan Ellman August 4, 2015 3:27 pm #

      Roseann,

      I use stock and ETF options but I have addressed the topic of index options in the past. Some major differences include option style (European vs. American), settlement (cash-settled) and settlement time among others. In my view, equity options offer much more strategy flexibility but I also believe that we can be successful with this strategy as well, if all aspects are mastered. I will be writing more about this topic in the future. here is a link to an article previously published on this topic:

      https://www.thebluecollarinvestor.com/index-options-and-exchange-traded-funds-options-a-comparison/

      Alan

  6. Adrian August 5, 2015 5:18 am #

    Alan, I have just been looking for a replacement stock and think I have found one. While considering if this is the best one I had got thinking of some things I wanted to ask about, so these are here:- 1. Is the 0.30c B/A spread and/or greater than 100c’s only required for the ATM strikes, or also for any strike I may want to use?

    2. When seeing the report I am wondering why to have ‘O.I’ as none when the options chain may have a B/A spread of greater than 0.30c?, – are we to eliminate any stock that has the ‘N’ for no open interest?

    3. There are times when I may be keen to change the original planned strike price I was going to use from the analysis of the day before, and was just wanting to know if it is alright to divert from my plan here?

    4. How many stocks should I have together as a minimum to analyze the returns, if I am only wanting 1 new stock?(how many per stock?)

    5. And for the above question, of this number of stocks how many should I have where they have reasonable returns to chose between and all got good liquidity too? (where if they haven’t then I would have to keep scouring for more to make up these odd ones which fall short)?

    Well I’ll get back to make a decision about this stock I have found. Thank you

    • Alan Ellman August 6, 2015 6:48 am #

      Adrian,

      My responses:

      1- Option liquidity standards apply to all strikes.

      2- Correct with the caveat that there may be a “Y” in that column in the following week’s report

      3- Absolutely, we base our investment decisions on the most recent information

      4- Set your goal for returns and keep in mind diversification (your not going to select a computer hardware stock if you already have others from that industry segment in your portfolio). Check our Premium Watch List (Running List) and select the strongest candidate. For example, you may look to stocks in bold with industry rankings of “A” (this is just one approach of many). Any selection should meet our liquidity standards.

      Alan

  7. Alan Ellman August 5, 2015 5:17 pm #

    Premium members:

    This week’s 6-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.

    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

  8. Steven August 6, 2015 5:48 am #

    Alan,

    Thanks for the very informative video series. If you had to ballpark guess what % of your covered calls do you just let expire vs. buying back to close? tnx again, steven

    • Alan Ellman August 6, 2015 5:53 am #

      Steven,

      Lots of factors will dictate my response…earnings reports coming up?, “moneyness” of strikes used that month, market behavior that month etc. Here is a general response for options overall:

      10% of options contracts end up being exercised, and 55-60% get closed out before expiration (including rolling options), that leaves about 30-35% of contracts that actually expire worthless.

      Alan

  9. Alan Ellman August 6, 2015 6:59 am #

    AAPL: Regular Dividend:

    AAPL will begin trading ex-dividend today with a $0.52 dividend payable to shareholders of record as of 08/10/15. The pay date is August 13th.

    Alan

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