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Selling Deep In-The-Money Calls to Exit Stock Positions

Covered call writing is used predominantly to generate cash flow in a low-risk manner. But it can also be used to exit stock positions while mitigating losses in those trades. As an example, I will use a series of trades shared with me by Ashvin on May 16th, 2019. The underlying security was iShares MSCI Brazil Capped ETF (NASDAQ: EWZ).

Ashvin’s trades

  • 1/17/2019: Buy EWZ at $43.09
  • 1/17/2019 – 4/22/2019: Write monthly out-of-the-money calls to generate cash flow
  • 5/16/2019: EWZ trading at $38.24 with the 5/17/2019 short call deep out-of-the-money
  • 5/16/2019: Looking for a plan to exit the under-performing EWZ and mitigate share loss

Ashvin’s proposed plan

Selling the 6/21/2019 deep in-the-money $22.50 strike would generate a bid premium of $19.60. Assuming the option is exercised at expiration, the loss per-share would shrink to $0.99 per-share. This would not even include the premiums generated to date. Here’s the math:

$43.09 (original purchase price) – [$19.60 (call premium) – $22.50 (shares sold at the strike)] = -$0.99

Breaking down the math with The Ellman Calculator

covered call writing calculations

EWZ Calculations with the Multiple Tab of The Ellman Calculator

The spreadsheet highlights some critical points we must be aware of when making our investment decisions:

  • There is a huge time-value return on our option of 17.2% which results in significant mitigation of share loss
  • There is also huge downside protection of 41.2% of that time-value profit

Digging deeper into these numbers

The option premium (time value + intrinsic value) tells us that the market is anticipating substantial volatility in EWZ and doesn’t specify direction. All the benefit and good news reflected in the spreadsheet must be tempered by the understanding of the risk to the downside for this high implied volatility security. If this trade is executed, it must be carefully monitored and perhaps closed should we see that downside protection eroding rapidly.

Discussion

Selling deep in-the-money call strikes is a viable way to close a long stock position and mitigate losses when there is a time-value component to the premium. Options that offer significant time value returns with substantial downside protection have high implied volatility and so we must be prepared with our exit strategy arsenal, if needed.

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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:

Alan, 

I calculated the past year’s paper-traded returns to an unbelievable 29.57%. These results could have been even higher because I didn’t play the B/A spread. I will definitely use this skill on real orders. So yeah with returns that high I actually can’t wait to start CC’s in real-time.

Adrian

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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.

27 Responses to “Selling Deep In-The-Money Calls to Exit Stock Positions”

  1. Ever November 2, 2019 5:12 am #

    Alan,

    Almost three weeks ago I sold an ITM call at 27.50 the stock was trading at $27 dollars I already own shares of (BAC). I received a premium of $84 dollars for a 30-day period.

    4 days before the option expired, I wanted to BTC the stock was at $31.59

    And the option cost to exit was $400 and some change.

    Please help me get it. It seems like I’m losing money of I close and the cost is much more than the premium I received.

    I called TD Ameritrade and the rep said if the stock would drop instead of going up I would have been able to do a BTC that would cost me less maybe below the premium purchased.

    Overall my capital appreciation is close to the BTC to preserve my premium plus the capital appreciation I earned after earnings report.

    Right now my logic and brief experience says that buying OTM that expire worthless are free money but anything else could trap you to pay more than what you originally got from the premium.

    Please assist me with this.

    Thanks,
    Ever

    • Alan Ellman November 2, 2019 8:18 am #

      Ever,

      It is important for covered call writers to master the concept of “time-value cost-to-close”. The situation was much brighter than initially analyzed.

      Let’s break down this trade:

      The trade was set-up for a 3.1% initial time-value return (see screenshot below) with an additional 1.9% upside… a potential 5%, 30-day return which was realized at expiration as the strike was in-the-money. So far so good. In return for undertaking this obligation, we agree that our shares cannot be worth more than $27.50 during the contract.

      As expiration approaches, we must decide to either buy back the option or allow assignment. The choice is ours as we have achieved a maximum return on this trade… 5% in 30 days… we should celebrate!

      Let’s say the cost-to-close is $4.20. With the stock trading at $31.59, the strike is $4.09 in-the-money. If we buy-to-close the $27.50 short call, our shares are now worth $31.59, a share value gain of $4.09. This is the intrinsic-value of the BTC premium. If we pay for this benefit then we must count the result as a credit. The actual time-value cost-to-close now becomes $4.20 – $4.09 or $0.11. This puts us in a position to either roll-out or roll-out-and-up and continue the income generation process.

      Bottom line: It is the time-value cost-to-close that will assist us in determining when to close an in-the-money strike, not the premium including the intrinsic value. This example also highlights the need to keep a 2% – 3% cash reserve in our account for potential exit strategy execution.

      For more information on this topic, see pages 134 – 142 in The Complete Encyclopedia for Covered Call Writing- classic edition.

      Congratulations on a very successful trade.

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

      Alan

      • Ever November 2, 2019 12:46 pm #

        Thanks for the very very clear explanation. I add 3% of reserves moving forward and I will account for share appreciation when calculating the BTC instead of just the premium cost and the BTC cost.

  2. Mark November 2, 2019 11:24 am #

    Alan,

    I wanted to give you an update on my TEAM position.

    I ended up holding TEAM after earnings since the expiration date was 1 day after the earnings. It dropped from earnings but I didn’t panic. I looked at the chart, looked for some support & resistance and other areas that buyers were likely to be positioned. I watched some of your videos on what to do if a stock gaps down, and referenced your books that I own. Basically gave myself all the info I could to make an OBJECTIVE, not emotional decision.

    By 1st choosing a great performing stock in a great performing industry I was able to apply some fundamental analysis and technical analysis.

    Since my original strike was $120, the plan was created to sell if it got back to $120 and roll down or just sell the position for a loss and move on if it did not move back up. TEAM ended up hitting around $126 a few days later after dropped to around 107.96 after earnings. When my alert sounded that TEAM had broken $120 2 days later, I stuck to the plan and sold, thereby keeping my original profit when I first sold the $120’s.

    I wanted to thank you for the library of videos I have access to, the books and also the email replay from you. Thank you so much.

    -Mark

    • Alan Ellman November 3, 2019 5:50 am #

      Mark,

      You made my day!

      I have printed out the components of your trade and will consider the info for a future blog article.

      Thanks for sharing and continued success,

      Alan

  3. Patrick November 2, 2019 5:23 pm #

    Alan.

    I have 2 questions that are really 2 versions of the same question.

    Within the subset of stocks which pass ALL of your screens:

    – Do you have a second level of technical analysis for deciding the EXACT moment when entry is most profitable?

    For example, another training I took recommended (for Covered Call writing) to enter a BuyWrite position when the stock was within 2 candles of a Daily Bollinger touch and within a day of the MACD crossing.

    – Do you see any statistical value to this type of secondary entry point.

    – For your trades, what technical signals do you use for entering a position?

    Thanks,

    Patrick

    • Alan Ellman November 3, 2019 6:26 am #

      Patrick,

      Technical analysis is critical to our stock selection process. It represents 1/3 of our watch list requirements (fundamental analysis, common-sense principles are the other two).

      I always encourage our members to use the indicators that meet their trading style and comfort level but I’m happy to share the parameters I have been using successfully for short-term option-selling for more than 2 decades. These include 20-day and 100-day exponential moving averages, MACD histogram, the stochastic oscillator and volume. I have not done a long-term analysis of the indicators in your question.

      We must also make sure that our technical requirements are not so restrictive that we miss cash-generating opportunities. Another factor is that we must sell our options at the beginning of a (monthly or weekly… I prefer Monthlys) contract as Theta (time-value erosion) will negatively impact the amount of premium we receive if we wait for technical parameters to pass 6 – 7 screens.

      I have not found the need to add additional indicators to our screening process but I’m open to feedback from our BCI community if we can improve upon our current process. If we do add additional indicators, we must make sure that it is not so restrictive that it impedes a reasonable number of eligible stocks.

      We encourage meaningful analysis and discourage over-analysis.

      Alan

  4. Barry B November 3, 2019 1:41 am #

    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 11/01/19.

    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]

    • Alan Ellman November 3, 2019 5:46 am #

      Premium members:

      Try printing pages 15 – 17 of the stock reports in “landscape” mode. The font is easy to read.

      Alan

  5. Jay November 3, 2019 6:01 pm #

    Hey Friends,

    As an “old buzzard” around here who has been with Alan and Barry on this blog and other material a while my hunch is they feel a deserved pride in how far this blog has come !?

    Everyone’s questions are now so insightful and superb – even from our newest contributors who we welcome since we were all there!. The answers are sometimes good too – poking fun at A&B :)!

    I love how friends are now describing trades start to finish with their own learnings, conclusions and follow ups.

    A&B always talk about the three essential skills of successful options selling. Yet that implies one has already answered the main question: “Why am I trading options in the first place?”

    If the answer is the conservative generation of cash flow with risk management strategies you are home! If it is to make the doubles and triples the info-mercial ads brag about this is not your place :).

    I do both not because I am playing Lotto covering many numbers but because I have different objectives for different accounts or even buckets of money within one. Market Madness is my main incurable affliction but I do my homework :)!

    All that said – thanks for still reading if you made it this far – it helped me to think first about why I wanted to trade options then spend time studying before doing it.

    A successful new week to all – Jay

  6. Tay November 3, 2019 6:31 pm #

    Hi Alan,

    The BCI 11-1-19 report date for the Weekly Stock Screen shows for ticker symbol INFO an ER date of 11-12-19. I like the stock as a possible investment and then sell the covered call, if I purchased the stock.

    Per the company (INFO) and the investor section on the website, it is actually a “Guidance Call” on 11-12-19 and not an “Earning Report”. The last 2 ER for INFO were in June, 2019 and September, 2019 respectively.

    Should we treat the “Guidance Call” on 11-12/19 the same as an ER?

    I would think, yes… as the reaction to the “Guidance Call” could cause a sufficient price increase or decrease, depending on what was announced.

    Thank you!

    Tay

    • Alan Ellman November 4, 2019 7:37 am #

      Tay,

      I agree with you 100%. If we have a guidance date in advance, it does represent potential risk to the downside. There are plenty of other eligible candidates to select from.

      earningswhispers.com has the ER date as November 12th and confirmed… see screenshot below.

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

      Alan

  7. Robert November 3, 2019 6:37 pm #

    Alan,

    Sorry if I missed it in the notes and guidelines but what is the meaning of the dotted background in the yellow section of the Premium Report?

    Thanks,
    Robert

    • Barry B November 3, 2019 9:55 pm #

      Hi Robert,

      The dotted pattern in the yellow section indicates the stocks that will be reporting earnings in the week following the uploading of the Weekly Report.

      Best,

      Barry and The Blue Collar Investor Team

    • Barry B November 4, 2019 11:29 am #

      Hi Robert,

      After reviewing your question and my earlier reply, I’ve changed the “Notes And Guidelines” section to better explain the dotted pattern area. It will begin in the next report.

      Thanks for the heads up.

      Best,

      Barry

  8. Ken November 3, 2019 10:35 pm #

    Hi Alan,

    Some covered call guides discourage using pharmaceutical stocks, as they have the tendency to gap up/down during FDA announcements. The weekly screener contains some pharmaceuticals like AMED, EW, CELG, etc. What’s your take on this?

    Also, is it a good idea to avoid stocks that are related to upcoming market events for the week? I.e., avoiding real estate stocks during real estate market sales reports. A couple of weeks back, I bought ODFL, and during that week, weak manufacturing output data was released, bringing down transportation/logistics stocks.

    One last thing — is it safe to buy stocks and sell calls the day after a gap up due to earnings report? I’m anxious that the market overreacted on the positive ER and people might take profits, especially on those juicy >8% gap ups. Do you wait a certain time until the price “stabilizes”? Or do you ride on the momentum of the positive ER?

    Thanks,
    Ken

    • Alan Ellman November 4, 2019 8:26 am #

      Ken,

      As one presidential candidate would say… “I have a plan for that”

      1. The use of pharmaceuticals will depend on the personal risk-tolerance of the investor. Some are performing at elite levels as the ones you mentioned in the post. Most will have a high-Beta (CELG is an exception) reflecting a higher level of historical volatility. We keep ourselves out-of-trouble by sticking with our initial time-value return goals (2% – 4% in my case). If there is an expected FDA announcement, the implied volatility (IV) will rise driving our potential returns above this range and we then opt for another security. We should never be enticed by high premiums.

      2. Economic reports come out nearly every day (see the economic report summaries in our weekly stock reports) and they have the potential to impact the market or a particular industry either way. As long as the IV of a stock keeps us in our pre-determined initial time-value return goal range, these stocks remain eligible. As always, we have our exit strategy arsenal prepared and ready to go, if needed. We want to avoid a system that is so restrictive that our pool of candidates is limited.

      3. A favorable ER that results in a gap-up will reflect an initial volatility that will subside. It may take a day or two. Let’s say a $60.00 stock reports after market close on Monday and gaps-up to $65.00 when market opens on Tuesday. I enter my trades between 11 AM and 3 PM ET so Tuesday would be too early. In most cases, Wednesday between 11 AM and 3 PM would be my entry point.

      Alan

  9. Chris November 4, 2019 2:27 pm #

    Alan,

    My brain takes some time to wrap around all of the info and get familiar with things from the selling of calls perspective and the selling of puts perspective.. I’m am primarily selling puts. I have 2 questions:

    Let’s use the current 11/01/2019 BCI Weekly Stock Screen and Watch list:

    1. You show the Put/Call Ratio as 0.77 and state “ This is a contrarian sentiment indicator. It is the Put Volume divided by the Call Volume. A ratio of >1 indicates a Bearish market trend. A ratio of <1 indicates a Bullish market trend.”
    So with more call volume than put volume it would seem to me that more people think the market will rise and less people think the market will fall. When you say contrarian, do you mean to assume a BCI should assume the opposite, or if not, what do you mean by contrarian sentiment indicator?

    2. You recommend Out of the Money Strikes 2:1. Is that for calls only, or for selling calls and selling puts? If not both, what does it mean for selling puts?

    Thanks again.
    Chris

    • Alan Ellman November 5, 2019 7:09 am #

      Chris,

      1. The put-call ratio is a psychological market indicator. In the BCI methodology, it is a secondary indicator used to be part of a broad mosaic used to determine overall market sentiment. The stat helps investors gauge market sentiment before the market turns. The thinking is that when sentiment is overly bullish, a bearish trend is right around the corner and vice-versa. This is why it is referred to as a contrarian sentiment indicator. It is never used by itself but rather along with other factors like charts of the S&P 500, the CBOE VIX, the GMI, IBD assessment and weekly economic reports.

      2. The BCI assessment found in the “Market Tone” section of our premium member stock reports relates to call options. The current 2-to-1 ratio means I am bullish on the current market conditions as of market close last Friday. As far as puts: I only sell out-of-the-money puts either to generate income or to buy a stock at a “discount” The main reason integrate puts into my portfolio is when I’m employing the PCP strategy (put-call-put… see pages 231 – 237 of my book, “Selling Cash-Secured Puts”). I like this strategy in bearish or volatile market conditions. A useful sale of an in-the-money put would be to buy a stock at a discount that we want that security in our portfolio sooner rather than later.

      Alan

  10. Ted November 5, 2019 10:29 am #

    Alan,

    Is there a way to better understand the possible “winners” in an options chain? If the Calls have a greater open interest and higher premiums (implied volatility) than the Puts, doesn’t it usually play out in their favor? Just wondering.

    – Ted

    • Alan Ellman November 6, 2019 7:32 am #

      Ted,

      When analyzing an option chain, we must focus in on the factors that will allow us to achieve our strategy goals. Here’s how I do it:

      1. Determine the “moneyness” of our option (ITM, ATM, OTM)

      2. Determine our initial time-value return goal range (2% – 4% in my case)

      Once we have defined these 2 factors, the best option choice becomes apparent. The market tends to eliminate any arbitrage opportunities regarding over- or under-priced options.

      That said, we do publish put/call ratio stats in our premium member stock reports that represents a secondary (and contrarian) parameter when evaluating overall market assessment.

      Alan

  11. Alan Ellman November 6, 2019 6:43 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

  12. Marty November 7, 2019 1:29 am #

    Alan:

    As an ardent BCI Investor and user of many of your books and your other writings, I think this is one (“Exit Strategies for Covered Call Writing”) of the, if not the best! Others pay attention to starting the call but very little on the exit.

    Now my question. I have not been able to locate charts (history of call) as seen on page 107, figure 58 and p 108, fig. 59. Is this a pay for service?

    Thanks in advance.

    Marty

    • Alan Ellman November 7, 2019 6:39 am #

      Marty,

      I used a pay-for-service to access those option charts. That service is no longer available. A decent free service for option charts is as follows:

      http://www.marketwatch.com

      • Enter stock ticker in search box, upper right

      • Click on “options” at bottom of page

      • Find strike and click on “quote” on the left side

      • Graph of price history appears

      • Can add a ticker of a stock or index for comparison

      Alan

      • Marty November 7, 2019 4:35 pm #

        Alan:

        Many thanks. You are the best!

        Marty

  13. Richard, November 7, 2019 3:06 am #

    Alan,

    I am trying to find if BCI has ever addressed the issue of how selling covered calls might adversely affect the tax status of [otherwise] “qualified” dividends from the underlying security.

    If so, where could I find it? Since “qualified” dividends get much more favorable tax treatment than “ordinary” dividends, I think this would be a worthy topic to discuss, even if the problem only arises in special circumstances.

    Thank you.
    Richard

    • Alan Ellman November 7, 2019 7:13 am #

      Richard,

      I had a CPA, who follows the BCI methodology, write the tax chapter in “The Complete Encyclopedia for Covered Call Writing”

      I am not an expert nor am I qualified to give specific tax advice but I can provide a few thoughts that you may find useful.

      1. I always view tax as a minor annoyance and not a factor that should shape our trading style. The focus of covered call writing is to generate cash flow not to avoid taxes. In the case of qualified dividends, we are paying tax, just at a lower rate than non-qualified.

      2. My understanding is that for a dividend to be qualified, we must own the stock for 61 days out of the 121 days surrounding the dividend record date. It is more important to avoid earnings reports and use the very best underlyings than to pay dividend income at a lower rate. Let’s not get distracted by minor annoyances and focus like a laser on the factors that will ultimately make us financially independent.

      3. Whenever possible, we should trade in sheltered accounts, Covered call writing is universally permitted in self-directed IRAs. If we can, taxes are no longer an issue.

      Alan

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