Contract adjustments for covered call writing and put-selling are not uncommon events and we must be prepared when they occur. From time to time a certain corporate event will take place that will alter the terms of an equity options contract, making it different from the original standardized terms such as the number of deliverable shares.
Let’s first list some of the most common events that lead to contract adjustments:
- Stock splits
- Special 1-time dividends
When a special 1-time cash-dividend is distributed option contracts will be adjusted to make both buyers and sellers of option contracts “whole” Generally, call options will move down in value by the amount of the dividend and put options will increase in price. The holder of a call option will be made “whole” by decreasing the strike price by the amount of the 1-time distribution. Let’s assume a stock is trading at $50.00 per share and a special 1-time cash dividend of $1.00 goes ex-dividend (date by which shares must be owned to be eligible to receive the dividend). The price of the stock will drop by $1.00, all other factors remaining the same. This is not fair to a call buyer so the strike is adjusted accordingly, by $1.00 in this hypothetical. A $50.00 call strike price is changed to a $49.00 strike price. In certain situations, the dividend distribution is less than the announced amount and the strike reduction is also less than the expected adjustment. This is the case with American Depository Receipts (ADRs).
What are American Depository Receipts (ADRs)?
These are negotiable certificates issued by U.S. banks representing a specified number of shares (or one share) in a foreign stock that is traded on a U.S. exchange. ADRs are denominated in U.S. dollars, with the underlying security held by a U.S. financial institution overseas. ADRs help to reduce administration and duty costs that would otherwise be levied on each transaction. Since there is now a “middle-man” involved in these trades, there is frequently a fee imposed by the bank to administer these 1-time special dividends. This means that the net amount received would be less than the announced distribution. In the above example, if the net dividend was $0.98 instead of $1.00, the $50.00 strike would be adjusted to $49.02.
Real-life example with New Oriental Education & Technology Group (NYSE: EDU)
EDU is a Chinese company trading on the New York Stock Exchange as an ADR. On 9/1/2017 the company went ex-date with a special 1-time cash dividend of $0.45-per-share. The bank administering the transaction imposed a $0.02-per-share fee making the net distribution $0.43-per-share. Strike prices were adjusted by the net amount, not the announced distribution amount. This explains the unusual strike prices shown in the screenshot below:
As with all contract adjustments, buyers and sellers of both calls and puts are made “whole” as a result of these alterations. Contract adjustments are not all managed in the same manner so it is important to research or inquire when we see unusual strike prices. Some excellent free sites include:
Contract adjustments are alterations made in our option contracts in response to a corporate action. Special 1-time cash dividends frequently will result in a change in strike prices. For ADRs, the net amount is the key to both the dividend received and the strike change.
Market conditions (opinion)
For many of us, recent market declines and enhanced volatility are unsettling but something we have experienced in the past multiple times. For new members, sleeping at night may be a challenge. I am currently fully invested and managing my positions as detailed in the BCI methodology. Only you can determine whether it is appropriate to remain fully invested or move to cash to some extent. All positive economic data is in place for continued corporate sales and earnings growth. The market is reacting to possible trade wars, the projected number of interest rate hikes, concerns of more vigorous US military involvement and uncertainty regarding US political dynamics. Historically, these events are short-term in nature and stability returns to the markets as long as corporations continue to make money. Of course, the situation requires close monitoring, something we routinely do in all market conditions. Whichever investment decisions we decide upon, fear and panic should not be part of the equation.
***Premium members may want to review our Emergency Management Report located in the “resources/downloads” section of your member site.
The Association for Technical Analysis (AFTA): Dallas Texas
“How to Generate Monthly Cash Flow and Buy a Stock at a Discount Using Two Low-Risk Options Strategies”
Tuesday April 17, 2018 6:30 PM – 9 PM
Crowne Plaza 14315 Midway Rd Addison, TX 75001-3505
This week’s economic news of importance:
- Existing home sales Feb 5.54 million (above expectations)
- Weekly jobless claims 3/17 229,000 (above expectations)
- Markit manufacturing PMI March 55.7 (expansion)
- Markit services PMI March 54.1 (expansion)
- Leading indicators Feb 0.6% (previous 0.8%)
- Durable goods Feb 3.1% (above expectations)
- New home sales Feb 618,000 (below expectations)
THE WEEK AHEAD
Mon March 26th
- Chicago Fed national activity index Feb
Tue March 27th
- Case-Shiller home price index Jan
- Consumer confidence index March
Wed March 28th
- GDP Q4
- Pending home sales Feb
Thu March 29th
- Weekly jobless claims through 3/24
- Personal income Feb
- Consumer spending Feb
- Consumer sentiment index March
Fri March 30th
- None: Good Friday
For the week, the S&P 500 declined by 5.95% for a year-to-date return of (-) 3.19%%
IBD: Uptrend under pressure
GMI: 2/6- Buy signal since market close of February 20, 2018 (approaching sell signal)
BCI: Moving to all in-the-money strikes. Currently fully invested and rolling down to out-of-the-money strikes (as they relate to current market value) when opportunities arise. Will re-adjust when the market settles.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a bearish outlook. In the past six months, the S&P 500 was up 1% while the VIX (24.87) moved up by140%. Historically, the VIX and S&P 500 are inversely related.
Wishing you much success,
Alan and the BCI team
The April edition of our Blue Chip (Dow 30) Report has been uploaded to your member site. 7 of the Dow 30 stocks have passed the BCI screens to be included in this month’s report.
Login to the member site and scroll down in the ‘resources/downloads” section (right side of page) to access the new Blue Chip Report.
Alan- Couple of quick questions on the PMCC:
Can you sell ITM calls on a PMCC like a regular covered call? Are there any special rules to consider?
If a stock has earnings coming up after the April expiration and you plan on being out of the position by then, would you still recommend buying your long call beyond the April expiration (6-9 months out?
The strategy can be constructed to meet your personal risk tolerance concerns but, generally, this is defined as a long-term commitment. As such, we use out-of-the-money strikes for the short calls (Weeklys or Monthlys…I prefer Monthlys) and deep in-the-money LEAPS for the long calls.
Short calls should not be in place through earnings report dates. Weeklys, if available, can be used to circumnavigate. Ex-dates can be avoided with Weeklys or writing 2-month short calls to move contract expirations further away from ex-dates.
In our BCI methodology, LEAPS are purchased 1-2 years out and rolled 3 months prior to contract expiration.
More information regarding the PMCC (“Covered Call Writing Alternative Strategies”) and a new calculator specific for this strategy will be available in April.
CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG
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 03/23/18.
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:
The April edition of our Blue Chip (Dow 30) Report has been uploaded to your member site. Seven (7) of the Dow 30 stocks have passed the BCI screens and are included in this month’s Blue Chip Report. To get the report, please log in to the member site and scroll down to the ‘resources/downloads” section (on the right side of the page) to access the new Blue Chip Report for April 2018.
Barry and The Blue Collar Investor Team
In your market tone you say “rolling down to out-of-the-money strikes…” If you are rolling down, isn’t the strike in-the-money?
I am referring to the “moneyness” of the strike as it relates to current market value. Let’s say we buy XYZ at $28 and sell the $30 call. Then XYZ drops to $23. We then roll down to the $25 strike which is out-of-the-money compared to the $23 current market value. This accomplished 2 goals:
1. Generate additional time value premium to mitigate losses
2. Allow for some share recovery up to the new $25 strike.
Just to clarify, as I understand your BCI strategy is from your previous blog and book comments, you really do not want to roll down unless you have executed the 20% or 10% rule, at which time you now have a long position and are offsetting at a low BTC price.
In the first half of the cycle, you might wait to see if you can hit the double, otherwise in the last half of the contract you can consider rolling down to mitigate the losses in the position.
If the underlying is in a volatile market or it itself is volatile (like now), the concern is the security might exceed the new rolled down strike, which at expiration will be assigned, but at an lower loss position or you roll to the next cycle (see next paragraph). The other option is, because of the volatility, to let the position stay long at the end of the current cycle decide if you want to write any additional options or unwind to cash.
Question – If one does roll down, and the price recovers to being in the money at the lower strike, have you ever rolled out or out and up, or do you simply let it get assigned and accept the lower loss obtained and look for another security?
I would like to share with you a trade I just made 30 minutes before the close today, which is closely related to your post.
I bought 200 shares of LOW @ 107.52 on Jan 29/18, and sold simultaneously 2 LOW 02/16/2018 107.00 C for 2.57 each.
On 02/02 I bought back the calls for 0.50 (20/10 rule).
I held the shares by mistake through earnings, but it made no difference. So I decided to wait.
On 03/09, I bought 100 more shares @ 86.75, bringing my average cost down to 100.60.
Today the market went up, and I sold 3 – 04/20/2018 90.00 C for 2.09 each.
So, if assigned my loss will be $ 11,101.00. 🙁
My reasoning today was:
“my LOW shares are @ 89.20, and the calls were sold for 2.09, so my ROO is 2.4%, plus potential for another 0.9% = total of 3.3% in 4 weeks”.
The original price payed is history.
My trotal loss if assigned will be $ 1932.00,
Sorry for typo.
Thanks for your comments. I followed your figures and calculated $2136 loss. or 6.6% from your original Return cost basis (RCB) of $107.
I came up with $1938 loss (close to $1932 you calculated) if you subtracted instead of adding the BTC cost of $0.50 to your BEP.
By adding the option leg at 90, you reduced your losses by 300 x 2.09 or $627 or 1.9% reduction in your loss.
I guess that you could, if the market tone and stock fundamentals / technicals were good again, you could keep rolling it to make your original investment results even better.
I did roll down CRM last month when the market slumped and CRM looked like it was in consolidation…. but CRM jumped back before Expiration date above my strike. I just predicted wrong.. but I still benefited from the roll down.
Excellent summary of some of our exit strategy tools.
When we roll down to an out-of-the-money strike (based on the new lower share price) and then there is a subsequent price recovery above the new (lower) strike, we consider rolling out or rolling out-and-up if the stock still meets our system criteria, including no earnings report in the next contract month. If the stock is still eligible and the calculations meet our goals, we roll. If not, we allow assignment.
Rolling down is a mitigating tool and in a high-implied volatility environment the direction of that volatility is not defined.
your calculations are correct.
I did get mixed up a bit because of the rush to respond, and because it was complicated by the additional 100 shares I bought later in the next options cycle.
I admire your skill in following the trade and revising the calculations in such detail.
There are almost 4 weeks left until expiry, and LOW is expected to report earnings on May 30, so plenty time for maybe improving my position as you observed.
But the issue I wanted to stress was that we must forget the original investment, and focus on the value of the shares at the time of deciding our next steps.
Thanks – Roni
I had a quick question, I understand not to get into a covered call position if an earnings report is coming up.
But what if I was in a covered call the month before and the shares didn’t get called away from me and I still own the stock.
Then that upcoming month there is an earnings report on that stock, shouldn’t I still sell a call on the stock to
generate some sort of income instead of just holding the stock and letting it sit there?
I never speak for Alan, he will get back to you, but your question is so fundamental to managing covered call positions I thought I would chime in.
I face your decision every quarter. I have adopted Alan’s Cardinal Rule that we should never have a covered call or cash secured put open on a stock – even if we plan to hold it – during an earnings report week. Why? Because those are the 4 weeks a year when the stock’s volatility is almost exclusively it’s own, not part of the broader trend. It could go anywhere.
Many short term covered call writers won’t even hold the stock during earnings reports to block downside! I am a portfolio over writer so I hopscotch those weeks using the weeklies and am only “out” 4 weeks a year of potential options cash flow from a holding.
If you use ETF’s for over writing this is all moot but the premiums are substantially lower. – Jay
Nothing to add to Jay’s comprehensive response so I’ll just summarize. Our choices in this scenario:
1. Sell the stock prior to the report.
2. Hold the stock through the report and write the call after the report passes.
3. If Weekly options are available, write calls through the earnings contract month except the week of the report.
Good morning Alan,
Thank you for the excellent responses.
Is it also a fact that the stock price declines on the ex dividend date equal to the dividend, making it less likely to be exercised?
Would higher volatility also deter you from being exercised?
Thanks again, Jake
Yes, both are true:
1. The stock price declines by the dividend amount on the ex-dividend date but many retail investors do not know this and may exercise early anyway to capture that dividend. Early exercise to capture a dividend is almost always a mistake on the part of the option-holder as selling the option and buying the stock to capture the dividend is a better path to take. However, early exercise is still possible.
2. Increased volatility of the underlying will result in an increase in the time value of the option, making selling the option more attractive than capturing the dividend.
I just finished reading the encyclopedia.
I grasped the general concept but need to re-read in order to grasp the details, especially chapters on Calculation, Greek and Exit Strategies.
For now, I just one question…
The strategy of Covered Call Writing consists of buying the stock, selling the option and deploying exit strategies. Can we perform this during after market hours? Or do we have to execute them during open market hours? The reason I ask is because I work from 6am to 4pm and it would be very difficult/impossible to trade while working.
It is absolutely possible to use these strategies while working a full-time job with the caveat that we must find an hour or two during the month to trade during market hours.
The preparation can be accomplished at night or over the weekend. The 20/10% guidelines can be automated after entering our trades.
Entering our trades or entering new trades must be done during market hours…perhaps 1 or 2 lunch hours per month. In the past this was difficult but with the technology now available, trades can be executed with ease from anywhere…I do it all the time.
Here is a link to an article I published a few years ago on this topic:
Hi Alan – I hope this email finds you well.
Quick question for you – I am at the paper trading stage of my education and a number of the Out of the Money Call Option Trades I wrote hit the strike price today. As soon as the share price hits the strike price, day 2 or any day in the option cycle – Will the option always be exercised? They will buy my shares and I am free to write another trade? Or take the cash etc etc.
Look forward to hearing from you.
We are dealing with American Style options which give the option buyers the right to exercise at any time. However, options are rarely exercised early for 2 main reasons:
1. Options buyers are looking to generate profit from option appreciation if they are directionally correct regarding the price movement of the underlying.
2. Option holders will make more money selling the option rather than exercising them as long as there is a time value component remaining in the option price which is typical.
When early exercise does occur, it is usually related to a dividend distribution (day prior to ex-dates).
If exercised, shares will be sold and the cash can be used to enter new trades.
Alan’s recent interview by a NASDAQ reporter in NYC:
Well, if you ever needed proof positive my market timing is terrible thus never listen to me I bought SPY and QQQ puts as protection Friday only to be handed two nice up days :)!
Oh well, I guess we insure our cars and houses against loss we hope to never use. A great week to all, – Jay
don’t worry about timing. Nobody can tell the future, and insurance is always a smart move.
After the dust settled, your gut appeared
to be correct.
Every blind squirrel finds a nut sometime. And while I am happy the puts are working it still stinks that the market is down :).
On we go….- Jay
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Alan and the BCI team
This is my first Covered Call trade and I didn’t know if this is correct calculations?
I purchased BX last week for $31.82 a share, then sold a March 29- $32 Call for .45 cents.
Today, I bought that $32 call back for .05 cents.
Then I also sold another April 6- $31.50 Call for .52 cents.
Was this a good idea? or should I have sold the same $32 strike?
Also, I’m not sure of my possible profit?
Is my cost basis in the stock $30.90?, if so and it gets called away next week would I make .60 cents per share?
Sorry, I know your busy and I won’t ask you questions like this again, I just wanted to see if I’m in the ballpark
Your calculations look accurate. I shares are sold for $31.50, we have a loss on the stock side of $0.32 and a gain on the option side of $0.92 for a net gain of $0.60 per share.
Strike selection when rolling depends on price of stock at the time of the “roll” (not shown in your inquiry) and overall and stock assessment.
Keep up the good work.
The price of the stock at the time of the roll was $31.40, does that make a difference in profit or loss?
No, final calculations do not change. However, if the $32.00 strike was originally sold, then rolling may not have been necessary…just sell the new option after expiration.
This may have actually resulted in a slightly higher return eliminating the buy-to-close cost.