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.

]]>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

]]>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.

]]>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

]]>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

]]>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

]]>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

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