beginners corner

Spin-offs and How they Impact Option Chains and Calculations

Corporate events can impact our covered call writing and put-selling positions in many ways. In today’s article we will focus on spin-offs and how to read an options chain after the event and calculate to moneyness of our options based on the specifics of that event.  Thanks to one of our members, Richard V., who shared with me this example, we have a great illustration to learn from.

 

Pre-spin-off trade (Ventas spinning off Care Capital Properties)

  • 7/13/2015: Buy 100 x  VTR
  • 7/13/2015: Sell 1 x Nov. $75.00 call
  • 7/30/2015: Notification of spin-off approval of CCP  by VTR Board of Directors
  • 8/17/2015: Spin-off distribution date: For every 100 shares of VTR owned, shareholder now owns 100 shares of VTR + 25 shares of CCP
  • 8/18/2015: Security ticker in the option contract symbols changes from VTR to VTR1 where the deliverable is now 100 shares of VTR + 25 shares of CCP

 

New and old option contracts

Pre-spin-off contracts continue to exist and trade on the exchanges until the last one expires. They now reflect the underlying VTR1. As time moves forward, new contracts are established for both VTR and CCP based on their current market values. Eventually, only contracts with the underlyings VTR and CCP will exist but not VTR1.

 

What happens to volume and open interest of restructured contracts (VTR1)?

These tend to dry up because many investors would rather stay with options contracts with standard deliverables (100 shares). Also, the moneyness of these options are frequently misunderstood. For example, when CCP spins-off from VTR, the value of VTR decreases by the value of that spin-off. Many retail investors will look at the $75.00 strike with VTR trading in the $50s and not want any part of it. They are missing the associated value of the CCP shares to really understand the moneyness of that option.

 

Options chain for VTR from 10/30/2015 with VTR trading at $53.78

 

contract adjustments and covered call writing

VTR options chain after spin-off

 

Notice that there are two November expiration $65.00 calls, one with VTR as the underlying and one with VTR1 as the underlying. Both deliver 100 shares of VTR but VTR1 also delivers 25 shares of CCP and that’s why the “ask” is so much higher.

 

Calculating the moneyness of the VTR1 options

To determine the moneyness of the options (in-the-money, at-the-money or out-of-the-money), we must determine the value of the deliverable. Based on the structure of the spin-off, we calculate as follows:

VTR1 = VTR + 1/4 CCP or $53.78 + 1/4 $32.87 = $62.00

The $75.00 contract for VTR is $21.22 out-of-the-money ($75.00 – $53.78) while the VTR1 contract is $13.00 out-of-the-money ($75.00 – $62.00).

 

Discussion

Corporate events like mergers, acquisitions, spin-offs, one-time special cash dividends, stock splits and others frequently result in contract adjustments. This will impact information disseminated on the options chains and impact how we evaluate the moneyness of our options. It is critical to understand these changes if we find ourselves in this situation or better yet, avoid them whenever possible (with the exception of stock splits).

 

Blue Collar Scholar Competition: Our 6 winners are:

Where will S&P 500 be at year’s end?

(S&P 500 closed 2015 at 2044)

1st place: WT T (2044…wow!)

2nd place: Roni S (2050)

3rd place: Joe M (2036)

 

Best commentary

Michael M (1st place):

“Unfounded reaction to Fed decision on interest rate, the “lack” of investing by millennials, a weak energy sector and a still strong dollar will be major contributing factors causing the S&P sliding sideways to December 2015”. 

Francis M (2nd place):

“Expect the Fed to raise short-term interest rates in December which is what the market expects, indicating confidence in the US economy. This will be a positive market catalyst. When this is combined with positive seasonality typically experienced in December, I project a 5% increase from Friday’s close of 2089” 

Chris D (3rd place):

“With the economy getting back on its feet, I think the markets are going to see more consumer confidence. With the potential rate hike everyone seems to be talking about though, it might suffer a minor setback. I think it will rise, but a conservative rise”

Congratulations to our winners. We will be contacting you regarding your prizes. The BCI team will also be donating $5000.00 worth of my book, Stock Investing for Students” to our military heroes via the USO. Thanks to all our members who participated in this event.

 

Upcoming live appearances

1- Saturday January 23rd, 2016: Kansas City, Missouri

9 AM – 12:30 PM

Matt Ross Community Center

 

2- New York Stock Traders Expo

February 21st – 23rd

Marriott Marquis Hotel, NYC

http://www.newyorktradersexpo.com/expert-details.asp?speakerID=891071A

 

Events calendar

JUST ADDED:  I was recently invited to speak at The Money Show Las Vegas event on May 10th, 2016 at Caesar’s Palace.

Market tone

US and European equity markets momentary calmed after the strong employment report on Friday. By day’s end, the market was down again for a rough first week of the new year. During the week, the markets were concerned about a possible devaluation of the Chinese currency and its impact on global exports and imports. Other global concerns came from the Iran/Saudi Arabia conflict, North Korea’s bomb-testing, the 12% crash in the Chinese stock market and terrorism abroad. The markets were not happy but we’ve seen this before so should we be in or out of the stock market based on this past week? The VIX is now above 26, volatile territory in my view. We each must make our own personal risk tolerance decisions…either stay on the sidelines until the market calms or trade defensively considering in-the-money calls, deep-out-of-the-money puts, ETFs, low-beta stocks, inverse ETFs, protective puts and of course, our exit strategy arsenal. All techniques are detailed in my books and DVDs. This week’s reports:
• US December non-farm payrolls rose 292,000
• Unemployment rate remains at 5.0%
• Previous employment reports were revised upward by 50,000
• The Institute for Supply Management (ISM) manufacturing index slipped to 48.2 in December, the lowest level in six years
• The non-manufacturing ISM index dipped to 55.3 in December from 55.9 in November, but held well above the neutral level of 50
• Minutes of the December meeting of the Federal Open Market Committee of the US Federal Reserve showed that policymakers approached the first rate hike in nearly a decade with caution
• December auto sales set a record with a total of 17.5 million cars and light trucks sold in 2015

For the week, the S&P 500 declined by 5.96% for a year-to-date return of – 5.96%%.

Summary

IBD: Market in correction

GMI: 0/6- Sell signal since market close of December 10, 2015

BCI: Favoring deep out-of-the-money puts and in-the-money calls only. Reducing my monthly goal for initial returns to 2% – 3% to decrease volatility risk. Plan to get more aggressive when markets calm.

Best regards,,

Alan ([email protected])

 

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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 “Spin-offs and How they Impact Option Chains and Calculations”

  1. Ed January 9, 2016 8:50 am #

    Alan,

    What do you suggest the minimum amount to have to be able to successfully leverage your services?

    • Alan Ellman January 9, 2016 8:54 am #

      Ed,

      This is a guideline:

      To be properly diversified:

      Using ETFs: Between $10k – $15k

      Using individual stocks: Between $35k – $50k

      ***THE LEARNING PROCESS CAN START TODAY FOR ALL PORTFOLIO SIZES.

      Alan

  2. HB January 9, 2016 2:20 pm #

    I’ve been using “the wheel” fairly successfully for quite some time but I see the riskiest part of it as selling the puts. It’s easy to get caught in the downdraft of a falling stock – i.e. get put to at what seemed to be a reasonable stock price only to see the stock continue to fall. I end up owning the stock and have to risk selling calls at a level that won’t support overall profit if called away.
    Is there a recommended way to avoid falling into this trap? I suspect I should close out the puts if it looks like I might get put to but I’m unsure at what point this would be, i.e. how much loss to accept.
    Thanks
    HB

    • Alan Ellman January 10, 2016 7:32 am #

      HB,

      Entering a covered call trade by selling out-of-the-money puts is an excellent strategy, particularly in bear market environments. Your question is a good one because it highlights the need for position management techniques when trades turn against us. I would add that we should also have exit strategy maneuvers when trades turn out much better than anticipated.

      To your question: I have found that closing a put-sale trade when stock price moves 3% or more below the strike will generally help us manage declining share price. This technique is highlighted in my book and DVD program.

      Alan

  3. Barry B January 9, 2016 10:27 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 01/08/16.

    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 entering 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

  4. Mike January 10, 2016 1:37 am #

    Alan,

    Perhaps you could offer advice on a SKX covered call trade I’m down on so far. I’ve been rolling down to mitigate the loss but I’m still down.

    Here’s where I’m at so far.

    12/29/15 – Bought 200 shares of SKX at $31.18 ($6236 cost basis). Sold two 15 Jan 32 Calls for .75 cents, netting $150. This represented 2.4% ROO with an 82 cent kicker if assigned.

    1/5/16 – Stock declined to 29.84. I bought back the calls for .25 for a net gain of $100 or realized ROO of 1.6% in a week or so. So far so good.

    1/5/16- Rolled down and out to 15 Jan $31 Calls for .60 cents when stock was at $29.84. Captured $120 premium.

    1/6/16 – Stock kept falling. I closed the position again at .30; stock was at $28.64, netting $60.

    1/6/16 – Rolled out and down again to the 19 Feb $30 calls for $1.85. took advantage of the rising IV/VIX. Netted $370.

    1/8/216 – My position is still open but SKX keeps falling in this terrible market start. SKX closed at $26.77. I’m inclined to stay long as the market overall…no material changes to the stocks fundamentals.

    As I look at my position here’s where I’m at Alan.

    Stock cost basis: $6236

    Premiums collected: ($150 – $50 + $120 – $60 + $370) = $530

    Breakeven basis: $5706 or $28.53/sh.

    Unrealized stock loss as of 1/8/2016: $1.76/sh or $352 (SKX closed at $26.77)

    Current option ask price: 1.00

    No. of Days remaining to expiration: 42

    Next earnings report is 10 Feb so I’ll want to unwind the position before then

    No doubt, the $352 to-date unrealized loss is better than it could be without the offsetting premiums…but it’s still a loss. Ouch. Not a good way to start the new year

    I want to turn this trade into a winning net profit if possible. As I’m seeing, here are the scenarios going fwd and options.

    Scenario 1. Unwind. Take the pain and unwind the position for a net loss around $550 (sell stock at $26.77 or so and buy back the call at a $1 or so)

    Scenario 2. SKX continues to fall …perhaps to $25 at expiration (another 6.6% decline– on top of an already 14% stock decline since purchase)

    – Let Call expire. Goal is to keep any future covered call strike price above the total position cost basis ($28.53 so far)

    – Sell additional OTM puts perhaps to bring in more premium (but risk more capital)—perhaps at the 25 or 24 strike level

    – At $25, my unrealized losses would grow to $700 less any additional offsetting put premium I may bring in

    Scenario 3. SKX stops falling and ranges between $25 and $30 at expiration

    – Sell additional covered calls at a strike price greater than cost basis

    Scenario 4. SKX recovers and rises back above $30 at expiration (19 Feb)

    – Assigned. Sell stock at $30 or $6000, netting a profit of $1.47/sh ($30 – $28.53) or $294

    I’d appreciate any ideas to recover here Alan, that you may suggest that I’m not seeing.

    Thx much, Mike

    • Alan Ellman January 10, 2016 8:15 am #

      Mike,

      First let me say that your knowledge of the mathematics of your trades is impressive…you’ve done your homework!

      Now I cannot give specific financial advice in this venue but I can make some general comments you may find useful:

      1- Most of the pain you are experiencing is the result of overall market conditions which have impacted most securities. History tells us that this aspect will change as markets whipsaw as do individual stocks. In the long run, the stock market appreciates in value.

      2- Your focus is on cash recovery with the same disappointing stock. Not until your last paragraph do you address unwinding. What do we really care about, the stock or the cash invested in that security? If it’s the cash, where is that cash best placed? In SKX or another security?

      3- Are the fundamental, technical and common sense reasons you selected SKX still in place? This, in my view, is a more important focus than damage control with the same security only.

      4- Rolling down is an appropriate strategy for a declining stock but I almost never roll down and out, exposing myself to potential longer-term pain.

      5- Excellent point on unwinding prior to the earnings report. At its last report, SKX lost 30% in share value…talk about pain. By rolling down and out, this is now an issue.

      6- Unless there are tax issues (owning a stock at a low cost basis in a non-sheltered account), we should never feel obligated to stay with an under-performer long-term. How is that stock performing compared to the overall market? Are the reasons I liked the stock to begin with still in place?

      7- Even losing trades can be money-makers for us if we learn lessons that can be applied to future trades. The BCI methodology is based on mistakes I made over decades and how I learned to correct and enhance my trading skills.

      Mike, based on your question, you have an excellent skill set and your trading future looks bright.

      Alan

    • Vivek January 10, 2016 9:09 am #

      was SKX on the BCI weeklt list on 29th December when you bought the share??

      • Alan Ellman January 10, 2016 11:09 am #

        Vivek,

        SKS was not on our Premium Watch List in December. There was a technical breakdown in August as shown in the screenshot below so it couldn’t have made it through our screens. CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.

    • Roni January 10, 2016 1:08 pm #

      Excelent question Mike, and perfect description of this trade.

      I have had many such trades this year (2015), and gave back all my hard earned gains.
      .
      My lesson from this is ” it can always get worse”, and therefore, from now on I will bail out early from any trade that goes against me.
      Someone said : ” The first loss is the best loss ”

      So if I were you, I would get out of SKX immediately, while the getting out is good.

      Wait till the market calms down, and gain it back with new and diversified trades.

      Good luck – Roni

  5. Alan Ellman January 10, 2016 7:14 am #

    EMERGENCY MANAGEMENT REPORT:

    Premium members: Late last nght the BCI team published our weekly stock report and you will note that there are only 5 stocks on our “running list” all with mixed technicals. These 5 along with the 15 exchange-traded funds from the mid-week ETF Report are a much lower amount than the normal 40-60 candidates, a reflection of the difficult week the market experienced last week. Once the market settles, hopefully this week, that number will return to its historical levels.

    In the interim, I want to remind our members of our Emergency Management Report located in the “resources/downloads” section of the Premium site (right side of page). Scroll down to “E” The report discusses stock selection, option selection, position management and the use of puts in bear and volatile markets. Investing in a non-emotional manner is so important in all market conditions especially extreme situations like last week.

    Alan
    .

  6. Bev January 10, 2016 6:16 pm #

    The options desk told me to sell covered puts you need to also go short. So there is an equilibrium one is this true seems to make sense and how do I unwind to profit do I buy back the short first assuming it has dropped and then wait for the sp to rise? Not having a covered put had quite the impact on my margin whereas this stabilizes it is there anything else I should also be doing?

    • Alan Ellman January 11, 2016 8:01 am #

      Bev,

      I want to be sure we all understand the difference between “covered puts” and “cash-secured puts” On this site we study cash-secured puts where put options are sold and an appropriate amount of cash is placed into our brokerage account to secure a potential future stock purchase.

      Covered puts, on the other hand, involve shorting the put option AND shorting the stock. Here is the formula:

      Covered puts = Sell stock short (borrow shares from broker) + sell put option = short stock + short put option

      Here is a link to an article I published on this topic:

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

      Covered puts and cash-secured puts are often mistaken for the same strategy.

      Alan

  7. Sean January 11, 2016 5:36 pm #

    Hi Alan
    May I please ask you a question about your premium watchlist?
    Before we use the candidates in this watchlist do we need to do any further investigations or can start using them for covered call or cash secured puts?
    Also, when constructing this watchlist do you take into the consideration the implied volatility of the stock at the time of publishing the list is compared to its IV during the past year? In other words, is the IV high enough to earn us the premium that we are after?
    Many thanks
    Sean

    • Alan Ellman January 12, 2016 7:21 am #

      Sean,

      The Premium Watch List is a huge time-saver for our members. It takes the universe of thousands of stocks and exchange-traded funds and reduces it to 40-60 candidates, on average. (The current list is much smaller than normal due to the recent bear market). All the fundamental, technical and common-sense screening is done for you.

      Once the list is published each investor will make final selections based on overall market assessment, personal risk-tolerance and portfolio size and mix. We must research option chains for stocks we are interested in as IV changes as do premiums. In my view, the best way to deal with IV and return issues is to set goals for initial returns because this will directly reflect the IV of the underlying security and the degree of risk we are incurring. Use the Ellman Calculator to evaluate these returns. For me, it’s 2-4% per month for initial returns. In my mother’s account (ETFs) I set goals of 1-2% per month for initial returns. This will set parameters for risk without having to explore the Greeks. These stats can be tailored to each investors personal risk-tolerance.

      When my team sends me an email that the new report has been published (same email our members receive), I print it out and place it in front of my computer where it stays until the next report is available.

      These reports dramatically reduce the amount of time and effort involved in using option-selling strategies but do not eliminate them.

      Alan

  8. Scott January 12, 2016 7:37 am #

    Alan,

    I own three of your books, and have watched many of your videos. I truly enjoy the way you present the material.
    Two things that i have run into so far that have kind of stumped me.

    1.) When using the Monday edition of the IBD 50, I notice you said start by highlighting every stock with an “O” next to it. While using the 1/11/16 Monday edition you will notice EVERY stock is optional. Is this always the case?

    2.) When plugging these stocks into http://www.investors.com and looking for the 6 green lights on the smart select rankings; not one the IBD 50 have 6 green lights, In fact, most only have about 2.. Is this also a usual scenario.

    3.) Finally, I am very interested in learning about WEEKLYS, and how you would approach trading them. Could you guide me to any of your publications or others which speaks about these so that I may educate myself further?

    I am going to continue learning your system and paper trading for the next month, but plan on becoming a BCI elite member in the next month or so. Thank you for all the knowledge you have passed on
    .
    Respectfully,
    Scott

    • Alan Ellman January 12, 2016 7:45 am #

      Scott,

      Glad to help. My responses:

      1- No, there are usually a couple of stocks on the list that are not associated with options. Let’s wait for next week’s list to see if this was an aberration. I will say that options are getting incredibly popular and supply-and-demand is increasing the number of “optionable” stocks and ETFs. I can personally attest to that from the number of speaking invitations I receive.

      2- Check out ULTA (ranked #5) and SWHC (ranked #9)…both with 6 green circles…there are more

      3- Use the Google search tool at the top of our web pages and type in “Weeklys”

      Alan

  9. Troy January 12, 2016 11:46 am #

    Allan,

    With many list on the IBD, such as stock spotlight and stocks on the move, what is the advantage of the IBD 50 over the other list when making a covered call?

    Thanks
    Troy

    • Alan Ellman January 12, 2016 3:20 pm #

      Troy,

      The IBD has been such a successful resource for covered call writing over the years for a few reasons in my view. First, they stress corporate fundamentals which are favored by institutional investors…sales and earnings growth. Secondly, many of these securities are growth stories which carry with them decent implied volatility and therefore decent option premiums. keep in mind that the IBD 50 is only one resource and the screening process is just getting started from there. For our members, we scan a database of more than 3000 securities each week in addition to the IBD 50. The other resources you mention in your question are open for consideration as well. I don’t recommend hangi9ng our hats on only one resource but the IBD 50 should definitely be included.

      Alan

  10. Brad January 12, 2016 3:07 pm #

    Alan,

    I am currently working my way through both volumes of the Complete Encyclopedia for Covered Call Writing and have completed all the lessons on covered calls in the Beginners Corner of your website; both are very helpful.

    I am retired and would describe myself as an investor and definitely not a trader. I have a highly diversified portfolio of approximately 65 different holdings, 90% of which are large cap stocks, and 90% of which are good dividend paying investments. In other words, most of these holdings are large, very stable companies. I live off the income these investments generate and that is why I am primarily a buy-and-hold investor. But I sure wouldn’t mind making more income off my investments in the form of covered calls, if that is an appropriate strategy for someone like me.

    Would a strategy of writing mostly out-of-the-money covered calls at strike prices I could accept for selling my investments seem to make sense for a primary buy-and-hold investor? I am not overly concerned with downside risk during the period of any covered calls since short-term ups & downs are not the type of thing I react to in any evert and I tend to ride out the typical bear market.

    I thank you in advance for your attention to this inquiry.

    Brad

    • Alan Ellman January 12, 2016 3:28 pm #

      Brad,

      Covered call writing may be perfect for your needs. I refer to this approach as “portfolio overwriting” in my books. See:

      1: Pages 343 – 348 of the classic version of the Encyclopedia

      2: Pages 341 – 350 of Volume 2 of the Encyclopedia

      The key terms you will need to master are out-of-the-money strikes, ex-dividend dates and rolling options.

      Alan

    • Joe M January 12, 2016 4:48 pm #

      Brad, Your post could have been written by me. Although I have been selling covered calls for only 1 year now, I have finally found my niche with selling “far” OTM covered calls. This works well for me and my temperment. During the last 3 months I have banked 100% of my premium each month. Right now I sell only OTM (about 10 to 15 positions per month). I use TDAmeritrade. Their options page shows “Probability of OTM and ITM”. I like to use strike prices with around 80% probability OTM. Puts the odds in my favor. When I place an order with this strategy, I don’t split the bid and ask. I usually use the ask or even greater. I wait for the stock to gain a little strength and the trade to come to me. Sometimes it takes a day or two or three. Sometimes, not at all. When I do get a position called away, I’ve made my premium plus appreciation. I will then usually place an order to repurchase at the strike I lost it. Many times it fills within a short period of time.

      I’ve never seen this exact strategy discussed in this venue but it is just a more refined version of portfolio overwriting as discussed by Alan. This works extremely well in a sideways to down market such that we are currently experiencing. I expect to be called more often in an up market. That is one of the reasons I go “far” OTM. Of course, the further you go, the less premium you get but the safer you are.

      I hope some of this made sense.
      Joe M

      • Jay January 12, 2016 7:58 pm #

        Joe,

        Thanks for one of the best builds on one of the best post strings we have had in a while! When the going gets tough the tough get going :).

        Nothing has helped distressed core positions more in the past month than over writing covered calls. Well done!

        January is often a harsh mistress. But spring always flowers.

        Keep the faith, – Jay

  11. Marcia January 13, 2016 10:29 am #

    If you have a moment I have a question about selling in the money put. Stock is at $84.66. If a Put was sold with strike of $85. If my figures are correct the intrinsic value is .54 and the time value is .44. But I don’t understand what that means. And the only way I would obtain this stock would be if the stock price went above $85, correct. I have only 2 more of the Put videos to watch and have been enjoying them.

    Thank you for your time!

    Blessings
    Marcia

    • Alan Ellman January 13, 2016 11:10 am #

      Marcia,

      This will seem a bit complicated initially and will become second nature in the near future. Part of the reason it’s a bit tricky is because an $85 strike on a stock trading at $84.66 is in-the-money for puts but out-of-the-money for calls.

      The $85 put is in-the-money by $0.34 ($85.00 – $84.66), so that’s the intrinsic value component of the total premium. If the total premium was $2.00, the IV is $0.34 and the time value is $1.66.

      The shares will be put to you (unless you buy back the option) at expiration if the strike is in-the-money which means the stock price is LESS than the strike price (under $85.00). Put another way, the option buyer has the right to sell their shares to us at a higher price than current market value. If the strike was lower than market value, it would make no sense for the option holder to exercise.

      Alan

  12. Dennis January 13, 2016 11:17 am #

    Approximately how many stocks or etf’s do you hold or trade in your portfolio on a monthly or annual basis?

    Thank you
    Dennis

    • Alan Ellman January 13, 2016 11:21 am #

      Dennis,

      The appropriate number of positions will vary depending on portfolio size, ability (willingness) to manage a certain number of positions and experience. I’m happy to share with you what I do:

      I have a monthly mix of 15 – 25 stock positions totaling 50 – 100 contracts. I also trade a few ETFs in my mother’s account.

      Alan

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