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Selling LEAPS and Covered Call Writing

In our BCI methodology we favor Monthly or Weekly options for our short covered call writing positions. I am frequently asked why I don’t utilize LEAPS options (expire 9 – 24 months in the future) to garner a much higher premium and perhaps require less management time. Dan recently sent me a covered call trade he executed with SLV (iShares Silver Trust: NYSE) using LEAPS as the short call position. He noted that his assessment was that SLV was undervalued and expected appreciation over the long-term.

 

Dan’s Trade

  • 11/21/2016: Buy SLV at $16.04
  • 11/21/2016: Sell the January 2019 LEAPS for $2.92
  • 11/28/2016: Share price declines to $15.26
  • 11/28/2016: “Ask” price for the LEAPS falls to $2.49

 

Dan’s question

“Can I buy back the LEAPS to lock in a $43.00 per contract profit and then sell more LEAPS and if so, will I still be considered “covered” since I don’t have naked option-trading privileges.

 

Response and evaluation of tactic

When buying back the option, we still own the underlying shares so, yes, we are still in a covered position when selling the second round of LEAPS. But does this action benefit us? After one week of being in this position, buying back the short call and re-selling it will result in a net debit due to the spread (Buying at the “ask” costs more than the credit generated from selling the “bid”). In addition to the spread net debit, we are also incurring two unnecessary trading commissions. Position management is critical but there are many occasions when the best action is no action at all.

 

A look at the technical chart

covered call writing with LEAPS

The brown field shows a 21% loss in share value during the past three months. Although we may have reasons for a future price recovery, it would be more desirable to wait for technical confirmation of those expectations. If one were completely convinced of a bullish turnaround, we should consider selling out-of-the-money cash-secured puts before purchasing the security to give some downside protection.

 

Calculations can be deceiving

Let’s annualize the returns for a 1-month call option versus a 25-month LEAPS option. I am using the real-life options chain on 12/20/2016 when SLV was trading at $15.06. The 1-month January 2017 $15.00 call showed a published “bid” of $0.50 and the January 2019 $15.00 LEAPS had a published “bid” of $2.65. $2.65 is better than $0.50, right? WRONG…let’s calculate the annualized returns per contract.

1-month call: ($50.00/$1506.00) x 12 = 40% annualized

25-month LEAPS: [($265.00/$1506.00)/25 ] x 12 = 8.4% annualized

Using Monthlys will far supersede the returns of the 2-year LEAPS.

 

Another factor to consider

We select an underlying security for multiple reasons. In the BCI methodology we use fundamental analysis, technical analysis and common sense principles and then make sure the security options will meet our goals and personal risk-tolerance. When we select a stock today that meets our system criteria, those parameters may not exist in the near or distant future and yet LEAPS imply taking a one-year or two-year obligation.

 

Discussion

Using LEAPS as our short call positions with covered call writing creates unnecessary complications especially related to lower returns and the risk of depending on long-term future price movement. Our system should be set up to maximize profits and minimize our risks. In my view, Monthlys provide the best combination of pros and cons although Weeklys can work as well.

 

Next live event

American Association of Individual Investors

Washington DC Chapter

Saturday July 15, 2017

9 AM – 12:00 PM

“Using Stock Options to Buy Stocks at a Discount and to Bring Portfolio Returns to Higher Levels”

Co-presenter: Dr. Eric Wish, Finance Professor, University of Maryland

More information

 

Market tone

Thursday started with the European Central Bank meeting, followed by ex-FBI director Comey’s testimony later in the day. It wound up with the Conservative Party in the UK losing its majority in the House of Commons. Despite increased uncertainty surrounding the Brexit process, global stocks have shown little net change on the week. West Texas Intermediate crude extended its decline to $45.50 from $47.35 a week ago after a forecast from the Energy Information Agency projected that US domestic oil output will top 10 million barrels a day in 2018. Equity volatility, as measured by the Chicago Board Options Exchange Volatility Index (VIX), remained historically low, slightly ticking up to 10.7. This week’s reports and international news of importance:  

  • Prime Minister Theresa May’s attempt to improve her Brexit bargaining position by calling a snap election did exactly the opposite, increasing the uncertainty around the Brexit process 
  • The Conservative Party lost its outright majority in the House of Commons but will be able to form a government with the backing of the 10 members of Northern Ireland’s Democratic Unionist Party 
  • Politically, May could be replaced as party leader in the near future. Early indications are that May’s failure to secure a larger parliamentary majority undermines the case for a “hard” Brexit. That is one reason — along with a weaker pound — that markets have taken the election outcome in stride so far. A softer Brexit is less disruptive to UK business interests 
  • With the economy on the upswing, European Central Bank president Mario Draghi announced on Thursday that the bank is dropping its bias toward cutting interest rates, but it retained its bias toward increasing quantitative easing, if necessary 
  • The bank raised its growth forecast while at the same time cutting its inflation outlook. Risks to the economy are now broadly balanced, he said. The overall tone of Draghi’s press conference was decidedly dovish 
  • Former FBI director James Comey testified before the Senate Intelligence Committee regarding the FBI’s investigation into Russia’s interference in the 2016 US presidential election and President Donald Trump’s desire that the Bureau end its investigation of his former national security advisor Michael Flynn. Comey said he would leave it to Special Counsel Robert Mueller to decide whether the president’s conduct rose to the level of obstruction of justice. With Mueller’s investigation in an early phase, there will likely be many months of continued policy paralysis in Washington 
  • Purchasing managers’ indices released this week show that the eurozone continues to outperform other developed economies. The eurozone composite PMI, which measures both manufacturing and services, stood at 56.8, unchanged from April
  • Meanwhile, the United States clocked in at 53.6 and the UK at 56.7, just below April’s 56.8 three-year high.  Japan’s composite PMI registered 52.6 and China’s 51.5            

THE WEEK AHEAD

MONDAY, JUNE 12th

  • Federal budget May 

TUESDAY, June 13th

  • NFIB small-business index May
  • Producer prices May 

WEDNESDAY, June 14th

  • Consumer prices May
  • Core consumer prices May
  • Retail sales May
  • Retail sales May
  • FOMC statement
  • Yellen press conference 

 THURSDAY, JUNE 15th

  • Weekly jobless claims 6/10
  • Philadelphia Fed survey June
  • Industrial production May
  • Home builders’ index June 

FRIDAY, JUNE 16th

  • Housing starts May
  • Univ. of Mich. consumer sentiment June

For the week, the S&P 500 moved lower by 0.30% for a year-to-date return of 8.62%. 

Summary 

IBD: Uptrend under pressure

GMI: 6/6- Buy signal since market close of April 21, 2017 (as of Friday morning)

BCI: I am fully invested in the stock portion of my portfolio currently holding an equal number of in-the-money and out-of-the-money strikes. I am concerned about the current political turmoil in the US how it may impact the stock market. So far, the market has been surprisingly resilient.

WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US

The 6-month charts point to a cautiously bullish outlook. In the past six months, the S&P 500 was up 7.5% while the VIX (10.30) moved down by 15%.

 

Much success to all,

Alan and the BCI team

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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.

28 Responses to “Selling LEAPS and Covered Call Writing”

  1. Jay June 10, 2017 12:20 pm #

    Alan,

    Thanks for another great blog as always!

    I have been paper trading some Jan 2019 LEAPS on SPY I “bought” a few months ago at a 1.0 delta. On the same day I “bought” an equal amount of SSO – the 2x ETF on the S&P. Interestingly they have tracked each other pretty closely which makes sense since the LEAP was half the price of SPY, was all intrinsic value and had no time value. I have not added the covered call component yet to the paper trial.

    What an intriguing market yesterday. The Q’s got a 2.5% haircut while the S&P barely budged. The bulk of QQQ is in the S&P. That told me money did not leave the party. It just moved out of the kitchen for a change :). – Jay

    • Geoff June 11, 2017 10:34 am #

      I’m a little concerned about the underlying fundamentals myself. Institutions are net sellers in the dark pools (disposing of stocks off-market) while the options market has the stock market pegged due to gamma exposure. Volume is a bit thinner, not uncommon for markets at all-time highs. The market pricing imbalance will resolve itself but I think we may see some more rocky action as we hit a more major expression cycle this Friday (June expiry).

      I have been increasing cash but I still took a bit of a haircut on Friday. I’m not sure whether we’ll see much of a bounce coming in on Monday as I expect more June contracts to be closing out throughout the week. I was running some bull put spreads, one more aggressively NTM on CERN which is underwater right now and EA is fine because that was a very chicken BPS I put on well OTM at a 106/103, a definite layup or bunt. Extremely high chance of win, little reward.

      • Jay June 11, 2017 12:13 pm #

        Geoff,

        I hope it is a good thing that our thoughts are similar these days :). I have built cash too, added GLD and TLT exposure, bought a few index puts and sold some closer to the money calls.

        The Stock Almanac folks say June is one of the worst months of the year so a correction may well have started. But I don’t see a crash because there is so much cautious sentiment and a lot of sideline money. Even though all the indexes are near record highs I don’t hear a lot of bullish euphoria out there!

        Good work on the EA credit spread, You still have $4.46 cushion. I have become the ultimate chicken with credit spreads after being too aggressive with them originally. I am happy to take consistent small winners! – Jay

    • spindr0 June 27, 2017 11:03 am #

      Buying a high delta call instead of the stock is known as a Stock Replacement Strategy. It will have a similar upside potential versus the stock and it has the potential to lose less, even far far less if the underlying collapses.

      If you sell a short term call against it, it is a diagonal spread which is also known as the Poor Man’s Covered Call. You can Google these terms for more info.

  2. Barry B June 10, 2017 10:19 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 06/09/17.

    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 BCI Team

    barry@thebluecollarinvestor.com

  3. Barry B June 11, 2017 3:23 pm #

    Premium Members,

    The Weekly Repoprt has been revised and uploaded to the Premium Member website. Look for the report dated 06/09/17-RevA. There were some minor formatting issues in the Market Overview section for some members. These have been addressed. The revisions didn’t impact any stocks in the report.

    Best,

    Barry and The Blue Collar Investor Team

  4. Jay June 11, 2017 6:00 pm #

    I suspect I am not alone enjoying market reading on Sunday afternoons thinking about the week ahead.

    I ran across the old Joe Kennedy Sr. story again in a bearish article. Many of you have likely heard a version of it.

    I do not know if is fact or fiction. I just know it is a great story 🙂 Legend has it Joe Sr. got a stock tip from his shoe shine boy. He then sold all of his stocks before the 1929 crash preserving his fortune. He knew if his shoe shine boy was in the market it was time to get out!

    I don’t think we are anywhere near that yet :).

    I hope everyone has a great week! – Jay

    • Barry B June 11, 2017 9:19 pm #

      Jay,

      I remember the internet bubble of 2000. I waa as getting tips from my waiter in a restaurant that my bride and I frequented. You knew what happened after that…

      Best,

      Barry

      • Jay June 11, 2017 11:26 pm #

        Thanks Barry. Isn’t it funny how those stories always turn out?

        Yet how wonderful a world would it be if every shoe shine boy and waiter was a market guru :)? – Jay

    • Roni June 15, 2017 2:47 pm #

      Hi Jay,

      yes, this is a great story, and proves that the stock market is a close cousin of the Ponzi scheme.
      When Joe Sr. heard that the shoeshines were buying stocks, he realized that the bottom of the pyramid had been reached, and there were no more suckers out there to fuel the growth.
      Which meant that the crash was about to happen.

      The same happened in 2000 whith the internet bouble as cited by Barry.

      In 2008, we had a simillar situation with the sub prime craze.
      Only a select few, who were able to fully understand the scheme, were able to withdraw in time.

      Every time the market gets the fever, there is a certain period where there are great opportunities and plenty of money to be made, but you must be very vigilant during such periods, and heed the red flags, to leave the party before it is over.

      Bernard Baruch said : “I made my money by selling too soon”

      Roni

  5. Terry June 12, 2017 7:40 am #

    Selling LEAPS and Covered Call Writing.

    Another factor is that this trade is considered a long diagonal spread and not a covered call. This requires a different level of trading approval is not allowed in retirement accounts by some brokerages.

    • Alan Ellman June 12, 2017 8:27 am #

      When we PURCHASE a LEAPS option instead of the underlying stock and then sell short calls (different strike and expiration) against that long position, it is known as a long call diagonal debit spread and will require a higher level of trading approval as Terry stated. Terry is also 100% correct that some brokerages will not allow this in self-directed IRA accounts but some are beginning to permit these. Many refer to this strategy as “The Poor Man’s Covered Call”

      Traditional covered call writing involves buying the stock (SLV in this article) or ETF first and then selling the corresponding call option. Expiration dates can vary although my personal preference is Monthlys but shorter or longer-term option expirations (LEAPS sold in this article) can be used. Traditional covered call writing is approved in self-directed IRA accounts across the board with all brokerages.

      Barry and I are co-authoring a book on covered call writing alternative strategies which will include a section on the Poor Man’s Covered Call (PMCC). I expect this book to be published later in 2017.

      Alan

  6. Alan Ellman June 12, 2017 12:39 pm #

    SINA: Contract adjustments:

    Last week I posted the fact that SINA was distributing 1 share of its holding WB for every 10 shares of SINA owned (10 per contract). This caused a share price gap-down as would a cash dividend distribution and alterations to the options contract.

    In the screenshot below, I have highlighted the important changes and non-changes.

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

    Alan

  7. Adrian June 13, 2017 3:46 am #

    Alan, Thanks for those answers last week, I sort of forgot you only rely on moving-averages rather than trendlines in your charts. A few answers to go over are:-
    1. In regards to the 20dEMA where at expiry you would sell any stock that is trading under it, but above the strike price, and then move into a different stock. There are occasions where the price can fall during the contract(alongside with the 20dEMA), but then pop-up above the 20dEMA, even though it is well below the strike price.
    Would you use the same stock the following contract now, or does it depend on performance?

    2. But I want to address your 1st reply next.
    Now as these Blue-chips are normally quite expensive(as I can see) and if you say I could use ‘Select Sector Spyders’, or maybe whatever other ETF that is cheaper, then is it alright to just use 1 or 2 Blue-chip stocks and make up the rest of my portfolio value with some ETF’s?

    3. And that of course brings me to this next longer question, from something else that I had experienced in similarity to the above, using high priced-stocks, and well it goes like this:-

    I could in all likelihood when ready use a $25,000 account value, where the maximum price is to be at just $50, and then wonder of this next situation when there simply aren’t any good stocks under $50 to even use.
    In some rare situation I may check premium report, see firstly not many on list, then of all stocks I mark under $50/share some I eliminate from no liquidity, some from no returns, more from technical concerns, perhaps the rest from ER’s, etc… Could I just keep searching through all others on the list (or the “Blue-chips”) up to say a $200 price limit where for 100sh’s = $20,000?
    4. And then for the $5,000 I had left (if I had initially used a $200 stock), use this on just ‘1 ETF’ worth up to $50?. (because you had said that 1 ETF is sufficient – seeing as these are already well diversified?)

    Hopefully you may agree there’s no problem using a higher priced stock or two in combination with any number of ETF’s.
    If so then great, because that really expands my stock search opportunities from a $50 limit, up to maybe $200 like I suggested above.
    Thanks very much.

    • Alan Ellman June 14, 2017 8:38 am #

      Adrian,

      1- Technical analysis is one of three parameters we use in the screening process and EMA is one of four technical parameters. If price dips below and then above the 20-d EMA by expiration, it is still eligible. If technical parameters are all bearish, we move on. If mixed, we consider ITM strikes….these are guidelines.

      2- Yes, absolutely, a combination of stocks and ETFs is a valid approach. I use only individual stocks generally, but during earnings season, I may turn to stocks and ETFs in my accounts.

      3 and 4- In a $25k account I would not consider 1 Blue Chip stock priced at $200 but rather look for better diversification opportunities…we will find them. For example, in the latest ETF Report, there are 9 securities priced under $50. I would feel more comfortable (for example) with one $100 stock + 3 ETFs priced under $50…just an example.

      Alan

      Alan

  8. Alan Ellman June 13, 2017 12:31 pm #

    Options Industry Council webinars:

    The OIC is offering four webinars this Thursday in their annual “summit”. Here is a registration link:

    http://event.on24.com/wcc/r/1415742/09C1E4C30D6F305835A065E19A0E2F1D/111901?partnerref=history

    As many of you know, I have been presenting webinars for the OIC and participating in their panel discussions for the past few years and know and support the quality of the educational material they provide.

    Alan

    • Jay June 13, 2017 8:49 pm #

      Alan, I could not agree with you more about OIC.

      My friends know the market is my thing so they ask me about it. I tell them to dollar cost average into index funds every month in their 401K’s and fund their IRA’s even if not deductible until they have the time and interest to study it more.

      When they ask about options if I sense they are serious I refer them here and to the OIC suggesting they start with covered calls.

      There is an old saying no one ever went broke taking profits.

      Well, no options trader ever went broke selling covered calls. There are plenty of ways to go broke in the options market! Covered calls is just not one of them :). If they lost money it was the stocks and how they managed them which is a different discussion. -Jay

  9. Alan Ellman June 14, 2017 6:03 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. 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

  10. Adrian June 15, 2017 2:58 am #

    Thanks Alan, I tend to agree too that $200/stock is a bit too high, so will taken into consideration only using up to maybe $100 for the stock price.
    That still opens up a few more stocks I can search through if feeling short rather than being restricted to around $50.
    My plan in ‘slightly bearish markets’ would probably be to search through Blue-chips before the ETF’s rather than the other way round, – but I’m guessing it doesn’t matter which order comes first.(or does it?)
    More questions to arrive soon.

    • Alan Ellman June 16, 2017 7:12 am #

      Adrian,

      Both lists consist of securities that are out-performing the S&P 500 over the past 3 months. The Blue Chip stocks have also out-performed the S&P 500 over the past 1 year. Both are excellent resources for option-selling securities.

      Alan

  11. MarioG June 16, 2017 12:50 am #

    Alan,

    Just noticed the following… 7/15/16 3pm,

    TUR, one of the highly rated ETFs, had very low Open Interest for EF 7/21 for all strikes near it Last Price/

    A. Until it meets Open Interest requirements, I assume we should ignore it if we are opening up a new position.
    B. In the case where there is a Roll out scenario to the next month, we can ignore the OI and just roll it and continue with your profits.

    Correct? See attached image..

    Mario G.

    • Alan Ellman June 16, 2017 7:08 am #

      Mario,

      The BCI guidelines are as follows:

      We require an open interest of 100 contracts or more and/or a bid-ask spread of $0.30 or less. I refer to these as guidelines to give the investor some flexibility.

      TUR is a security that has been on and off our ETF reports for years and is currently out-performing the S&P 500. In the screenshot, we see a low OI for the expiration date shown but reasonable bid-ask spreads. For these reasons, we left TUR on the eligible list but we all must re-check option liquidity, spreads and return calculations before entering a trade.

      The same guidelines apply when considering rolling options keeping in mind that even if option returns meet our goals, we still may need to close the short call at a favorable price so we don’t want the spreads too wide.

      Alan

  12. Dan June 16, 2017 4:23 am #

    Allen,

    Do you try to place your calls on a Monday for30 days or dose it matter?

    Thanks,
    Dan

    • Alan Ellman June 16, 2017 5:16 pm #

      Dan,

      When our trades are placed does matter because we are undertaking short-term obligations (monthly in most cases, some use Weeklys). Because time value erosion (Theta) can negatively impact the value of the premiums we generate, it is important to enter our trades early in the contract.

      As a guideline, I like to enter my trades in the first day or two of a 4-week contract or the first week of a 5-week contract. I do generally enter new trades on Mondays of the new contract cycle and prefer to execute these trades between the hours of 11 AM and 3 PM when market volatility is generally low.

      Alan

  13. MarioG June 16, 2017 6:29 am #

    FACT: TIME VALUE IS KING!

    Trading using Alan’s methodology revolves around the Time Value TV of a trade. Master it, and you are one step ahead in this game. It is not an easy concept at the beginning, but persistence and time and repetition leads to understanding.

    GAP UP;
    For Calls that Gap up or trend up and are ITM, TV approaches zero and you have to decide what to do. Options are A. Unwind the position and free up cash to add more profits in a cycle with another security or roll up if confident in the same security (weeks 1, 2, 3 of 4) or B. keep your position to Exp Fri and roll out or roll out and up when premium is high (intrinsic value) with TV low or C. Let it get assigned because of an upcoming earnings report.

    GAP DOWN:
    For calls that gap down or trend down and are OTM, the TV decreases (Intrinsic=0) and you apply the 20% of the premium paid for the first 2 weeks and 10% rule to the 3rd week of 4 to determined when to Buy to Close your option and wait if you stock price regains its original price for you to STO a new option and hit a double.

    At both Optionshouse and Fidelity, I add the Intrinsic and Time values to watch lists and Position windows. An advantage I see at Fidelity is that their watchlists also function as portfolios so you can recreate and combine accounts and see a complete picture of your accounts, including adding your option positions (50 position limit). Yahoo.com watch lists I have found to be unreliable for this (has not worked for me – options do not get updated, though you can add them).

    Important to note: The watchlists/portfolios in Fidelity use the LAST PRICE of an option to calculate the account values. I mention this because you will see a difference in your account values calculated by the brokerage houses. Fidelity Positions window (not the watch lists/Portfolios) use the Bid or Ask prices of an option when calculating end of day values (not fixed rule for all securities). Optionshouse uses the Mark of Midpoint price of an option. At the end, you may see account values differences of 0, $200, $500 or more depending on the cost of buying back your option position. That is no problem as long as you know the explanation.

    Since Fidelity’s watch list use the Last Price consistently, I can match exactly account values in a Profit Loss Spreadsheet (Alan’s 2015 Spreadsheet, which I have modified extensively) I use to track my trades and calculate current cycle gains (can zero out gains at start of each cycle). If my account values do not match, which I do weekly, I have an error, which is a good check on my numbers.

    Note: I myself have found the Spreadsheet is an excellent tool to understanding the relationships between the numbers.

    Back to the Time Value parameter when trading options, I have discovered an interesting relationship when trading ITM options.
    between the Exercise Price (E) and the Time Value (TV) of an option: I have not seen this documented anywhere. One main reason is because only Alan’s methodology (as he has mentioned) that I know of uses ITM options with Exit Strategies actively in a trading strategy.

    Fact: When calculating the value of a Buy-Write Net Debit Limit (Buy with STO), or a reversing Buy-Write Net Credit Limit the Price of the Stock does not matter and cancels out. The end result is you are guaranteed a TV if the trade is filled. Before I realized this, it was very puzzling to me as I played the spread as to what was actually happening to my numbers.

    Proof:
    L=Limit price used in ITM Buy-Write orders, Debit or Credit
    S=Stock Price, C= Call Premium, E= Exercise Price
    Int = Intrinsic, TV = Time Value

    L = S – C (Stock price – Call Premium)
    S = E + Int (Stock price equals Strike Plus Intrinsic)
    C= Int + TV (Call Premium equal Intrinsic plus Time Value)

    Combining the above two equations into the Limit:
    L = S-C
    L= E + Int -(Int+TV)
    L= E +Int -Int -TV)
    L= E-TV

    Net result: For an ITM Limit order, Opening Debit or Closing Credit, you are guaranteed a TV for the strike you selling or buying. Check it out, you get the same limit price without using the Stock price.

    When placing a Buy Write order and I know my time value, I just subtract the Strike price and get my limit price. That Time value is guaranteed (before commissions) if it is filled. Your ROO% is the TV / Strike price.

    I use a figure of merit of 0.1% – .0.2% for determining when to unwind an ITM position so you can use the cash elsewhere.
    I take the position’s Cost Basis for ROO (normally the strike price for your first opening ITM position or the Stock price for an OTM opening transaction) and use that to tell me when to place the trade.

    Example: if Cost Basis is Strike 40, then 0.1% loss in closing is a time value of 0.04. So I place a Limit order of 40 – .04 = 39.96. Your total loss for the trade if $4.00 for 1 contract, if commissions are zero..

    If you own 500 shares and your total commission is $10.00 (options and stock), then that adds $.02 per share to your original .0.04 expense and total loss for the exiting trade is 0.06 per share or 0.15% of 40 strike). total loss for 500 shares is $30, still at 0.15% loss.

    If I have a gain of 2-3% or larger in a trade, I do not mind losing 0.1 or 0.2% to close the position and use the cash elsewhere. I use this even to the week before expiration week, as I have found I can find often find (A) a trade with 1.2% or better or (B) possibly a trade when the market has taken a downturn and see some good buying opportunity by comparing Alan’s latest Run List performance, which I also track in a Fidelity Watch List with Price and quantity values..

    At $20,000 cash per trade (500 shares, 40 strike = $20,000) that is an additional $240 to the current cycle.. Net gain = $210 after considering your $30 loss in the security you just cashed out. Net gain = $210/$20000 = 1.05%

    Hope the above is useful and helpful.

    Mario G.

    .

  14. Alan Ellman June 16, 2017 5:12 pm #

    Mario,

    Great stuff! Your commentary reflects a deep mathematical understanding of the inner mechanisms of our covered call trades. After years of email contacts with you and having had the pleasure of meeting you and your family at one of my recent seminars, I must say that I am not surprised by the quality of your post.

    That said, I will predict that members new to BCI and option-selling may find the information presented in your post a bit intimidating. Our more experienced investors will love every printed word.

    So, to the “newbies” let me say that Mario’s formulas are spot on and either directly or indirectly reflect the formulas in the Ellman Calculators. It is not necessary to have a full understanding as to how the formulas in the spreadsheet were developed.

    An interesting aspect to your approach to selling ITM strikes is where positions are closed at a slight loss (0.1% to 0.2%). Using buy/write combination forms closes both legs of the trade. In the BCI methodology, we maintain the flexibility of working the short leg while retaining the long stock position. Of course, closing both positions is also one of our choices. This is where “hitting a double” and “rolling down” may come into play.

    On first glance, the advantage of closing both legs at a slight loss would have the benefit of less management requirements but the disadvantage of possibly leaving some exit strategy profit opportunities on the table. As I always say…one size does not fit all.

    Alan

    • MarioG June 17, 2017 2:16 am #

      Let me clarify.

      I do not want to leave the impression I am disagreeing with the BCI Methodology, I strictly follow it. As I state in the first 3 paragraphs, gapping up, I unwind (close both legs) and Gapping down, I follow the 20 / 10% Rule requirements and only close the option leg of the contract. I reference the Classic Encyclopedia below.

      GAP UP case: (Position ITM or In-the-Money)
      This is the Mid Contract Unwind where stock price increases and Time Value approaches Zero or some small value (Page 254 – Significant Acceleration of Share Price) and Pages 264-271 Mid Contract Unwind.

      On the bottom of Page 271, for a Mid contract unwind, “the option premium must be close to zero, and the new position must generate more cash than the amount of time value paid to close the original position.”

      Interpreting the above and using the example in Figure 95, Pg. 267, Strike = 50, Premium to close = 6.90, Stock price = 56.79, Intrinsic = 6.79, Time Value = 0.11 That means if you decide to Unwind, you will lose $0.11 per share or 0.11 / 50 = 0.22% of your Cost Basis. Original Investment = Strike 50 x 100 Shares = $5000. 0.22% of $5000 is $11.00.

      So when the book says “close to zero”, I had to quantify that to some value. I choose 0.1% because commission is not included. It usually adds another 0.1%, (for example, $10.00 worst case commission / 100 shares= $0.10 per share) so the total would be .0.2% which matches with the 0.22% or the book example..

      Interesting to note, to get the big picture, that original profit in the trade in Figure 95 is $100 (ROO=2%), so the $11 loss is actually 11% of your profit, but that is OK because you are in the “Week 1, 2 or more” of your contract and you feel you can find another security to make additional profits in the same cycle.

      To execute the mid contact unwind, since Time value is 0.11 in the book example, I would execute a Buy-Write unwind closing trade with a limit of L=E-TV = Strike price – Time Value = 50-.011 or 49.89. Or alternatively, the limit is from Page 27, 56.79 – 6.90 =49.89 (Stock price – Premium to close). Same number. Remember the L=E-TV equation works only for unwinding ITM Buy-Write transactions.

      Practically speaking, in the first weeks of a contract cycle, If you set a limit order with a time value of 0.1% of the ROO cost basis (strike or original purchase price), you will catch and add opportunities to make additional gains with a Mid Contract Unwind. If the original purchase was an ITM transaction, then the strike is your ROO Cost basis. For a Strike of 50, set limit to 49.95, 40 – set to 39.96, etc.

      *******

      Gap Down case (Position OTM Out of Money):
      I follow the 20/10% Rules in Weeks 1-3 and only close the Option Leg of the contract hoping to Hit a Double if and when the security price returns to near the original price. (Pages 250-254, 257-260 of Classic Encyclopedia.).

      ,*****

      Fidelity Watch Lists / Portfolio:
      One other point I want to add regarding using Fidelity Watch Lists / Portfolios to combine accounts and keep track of your Option contracts and account value. I combine 4 accounts and keep track of the Cash and Reserved cash (for CSPuts) separately for each account by using as dummy accounts Money market funds which have a NAV of $1.00. That way I can use the Quantity column to indicate the Cash amount. If combining 4 accounts, you need 8 Mutual funds, which is no problem to find, using multiple companies.

      Mario G.

      • Alan Ellman June 18, 2017 7:43 am #

        Mario,

        Thank you for this follow-up post. In my view, your equations are spot on and represent a mathematical quantification of the guideline found in my books and DVDs where it states that when a strike moves deep ITM, the position should be closed (mid-contract) when “time value approaches zero” It further states that the time value generated from a second position in the same month with the same cash (freed up from closing the original trade) should be greater than the cost-to-close ($0.11 in the example on page 268).

        Let’s look at the overall picture of this trade if we entered and exited with a buy/write combination form:

        With the stock trading at $51.10 and the $50 call generating $2.10, we would set a net debit limit order to open at $49 ($50 – $1) which matches your formula of E – TV. As you explained and your formulas reflect, this is the same as $51.10 – $2.10.

        With the stock trading at $56.79 (now deep ITM) we exit at $49.89 ($50 – $0.11) using the same formula. So we enter at $49 and exit at $49.89 profiting by $89 per contract (less commissions). This matches precisely the stat shown on page 268 of the Complete Encyclopedia-Classic.

        I’d call this a meeting of the minds!

        Alan

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