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Using Multiple Exit Strategies in the Same Contract Month

Covered call writers can be good at what they do or great at it. They can generate decent returns or the highest possible returns. One of the mission statements of The Blue Collar Investor is to assist each other in achieving the greatest levels of success. The implementation of exit strategies when indicated is critical to this end. Most covered call writers buy the stock, sell the option and then hope for the best. Not us! A few weeks ago I wrote an article highlighting the “mid-contract unwind” exit strategy where a covered call position is closed when the stock price rises and the time value of the option premium approaches zero (trades near “parity”). I referenced a trade I executed in one of my covered call portfolios (commissions not included):

February 21st:

Buy 300  x TPX @ $73.73 = $22,119

Sell 3 x March $70 calls @ $5.82

ROO (time value or profit) = $5.82 – $3.73 = $2.09 = 3% = $627

Intrinsic value of premium ($3.73) is used to “buy down” the cost basis from $73.73 to $70 (strike price) = $21,000

February 24th:

With TPX trading @ $78.05 and the March $70 call trading near parity @ $8.40, I executed the mid-contract unwind exit strategy:

Buy-to-close 3 x March $70 calls @ $8.40 = $2520

Additional value of shares by closing option = $78.05 – $70 = $8.05 x 300 = 2415

Cost to close = $0.35 ($8.40 – $8.05) x 300 = (-) $105

Sell 300 x TPX @ $78.05 = $23,415

Cash generated from stock sale: $23,415

Next I will show you the steps I took after unwinding the original TPX trade.

February 24th (cont):

I checked the stocks on my premium watch list

Buy 400 x RAX @ $53.42 = $21,368 (slightly less than my original investment of $22,119; slightly higher than the “bought down” cost basis of $21,000))

Sell 4 x March $55 calls @ $1.10 = 2% =  $440

Deducting the $105 from the $440 my additional income for utilizing this exit strategy is $335

Thus far I executed the mid-contract unwind exit strategy generating an additional $335 or 1.6% into my account. I also generated unrealized profit from the share appreciation of RAX from $53.42 to the strike sold ($55) = $1.58 x 400 = $632. Here is the 1-month realized and unrealized profit to date (see bold figures):

$627 + $335 + $632 = $1594

1-month return = $1594/$22,119 = 7.2%

Let’s now move forward to the day I am writing this article, Thursday March 15th, the day prior to expiration Friday.

March 15th: Rolling out exit strategy:

  • RAX trading @ $56.55
  • Buy-to-close 4 x March $55 calls @ $1.70
  • Sell-to-open 4 x April $55 calls @ $3.45
  • Initial profit = $3.45 – $1.70 = $1.75 x 400 = $700
  • This represents a 3.2%, 1-month return with 2.7% downside protection of that profit

Once I executed this rolling out exit strategy I went from attack mode (aka generating cash!) to management mode where I look for exit strategy opportunities.

Conclusion:

Using our arsenal of exit strategies will elevate our profits from decent to fabulous returns. It’s one of the critical factors that make Blue Collar Investors different from all the others. Not all trades work to perfection like the ones above but many do. In either case, being prepared to implement exit strategies will absolutely increase our bottom line results even if it is simply mitigating losses. There will always be some losses but our objective is to have many more winning trades than losing ones. In this week’s article, I demonstrated the use of the “mid-contract unwind” and “rolling out” exit strategies that resulted in a 2-month return of 10.4% as long as RAX does not decline below $55. If it does, I am prepared to act.

A note to our new members:

In the beginning it may appear that using these exit strategies is a daunting task. It did to me as well when I first started teaching myself this great strategy. I want to assure you that it will not take long to MASTER these strategies when they will become second nature to you. Learning these strategies will be time very well spent and cash very well received.

Register for my Atlanta Presentation:

I have been invited to be the focus speaker for the Atlanta Chapter of the American Association of Individual Investors (AAII) on Saturday April 14th @ 10AM. The venue is the beautiful Cobb Galleria Centre. The link to register ($10) has just been posted:

http://www.aaii-atlanta.com/events/54170712/?a=wm1_6&eventId=54170712&action=detail&rv=wm1&rv=wm1

Market tone:

As has been the case the past few months, last week’s economic reports reflect a strengthening recovery:

  • The core Consumer Price Index (CPI) which excludes volatile food and energy prices rose only 0.1% in February, a positive for those concerned about inflation
  • Overall industrial production for February remained unchanged while manufacturing output was up 0.3%
  • February retail sales rose 1.1%, the best showing since September, 2011
  • The Fed made no change to monetary policy with short-term interest rates near zero through 2014
  • The Fed expects “moderate ” growth in 2012, a bullish comment
  • Initial jobless claims for the week ended March 10th came in at 351,000 less than the 359,000 expected

For the week, the S&P 500 was up 2.4% for a year-to-date return of 12.2%.

A review of a 6-month price chart of the S&P 500 shows an uptrending 50-d simple moving average and a bullish moving average crossover in early February:

Market tone as of 3-16--12

Summary:

IBD: Confirmed uptrend

BCI: Moderately bullish, laddering strikes but favoring out-of-the-money strikes as the overall recovery seems to be gaining momentum.

Wishing you the best in investing,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

 

 

 

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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.

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32 Responses to “Using Multiple Exit Strategies in the Same Contract Month”

  1. Tom March 17, 2012 8:21 am #

    Alan,

    What factors do you use to determine if you roll out as you did with rax or out and up? Thanks. I love these real life examples.

    Tom

    • Alan Ellman March 18, 2012 3:16 pm #

      Tom,

      Rolling out and up is a more bullish exit strategy approach. I factor in the following:

      1- Market tone

      2- Stock technicals

      3- Calculations

      If the market and price chart are bullish and the calculations meet my goals (2% – 4% per month) I will roll out and up. A lot also depends on your personal risk tolerance as rolling out will ALWAYS provide downside protection of the option premium.

      Alan

  2. Tara March 17, 2012 11:11 am #

    Alan,

    Thanks for these articles. They have opened my eyes to strategies I never thought of and have increased my profits significantly. Thanks for all you do.

    Tara

    • Alan Ellman March 18, 2012 3:18 pm #

      Thanks Tara. It’s great having you part of our BCI community.

      Alan

  3. Marty March 18, 2012 11:16 am #

    I did a simpler approach to calculating the results of these transactions and got a different answer.
    Cost of 300 shares less option premium is $20,373.
    Closing 300 shares plus cost of option buy back is $21,640
    Net return of $522.

    Return without options in transaction $1,296

    Cost of 400 shares less option premium is $20,928
    Closing of 400 shares plus cost of buybac is $21,640
    Net return is $712

    Return without options is $1,252

    Total return using option sale over 30 days is $1,234 or 5.5%

    Total return just buying and selling exact same without selling options is $2,548 or 11.5%

    I did not factor the value of selling the April 55 calls into either transaction.

    Yes, there is no downside protection without selling the calls, but during a major correction you only save your option premium and you cannot put use a stop loss to sell your shares until you buy back your options assuming you are restricted to covered calls.

    What am I missing?

    • Alan Ellman March 18, 2012 4:05 pm #

      Marty,

      There is nothing wrong with your math. It is just computed from a different perspective, an after-the-fact perspective. This is the way an accountant would compute these results let’s say for tax purposes.

      What I do (and the Ellman Calculator is based on) in these real life examples is a current view of a trade as a step-by-step analysis to allow the investor to make the best decision at that point in time. We have included the Schedule D as part of the Elite version of the Ellman Calculator for final calculations.

      For example, in step 1 you deduct the entire option premium from your cost basis. In retrospect this is correct. However, at the time the trade is executed, we know the time value and intrinsic value of the premium but don’t know the outcome. To decide if this initial first step is a trade we want to make, I calculate the time value as initial profit and the intrinsic value as protection of that profit. By breaking it down this way, we can see the benefits of this particular option versus other strike prices. In the BCI methodology we re-invest that profit to compound our initial profits. This concept of compounding is an inherent part of the BCI methodology and the reason I do NOT incorporate time value into decreasing the cost basis. Therefore, I don’t deduct time value from my cost basis, only intrinsic value. In my books and DVDs I make it clear, not to use these calculations for tax purposes. They are to be used to assist in making the best investment decisions at that point in time. In my view, this is the approach that is most benefial to retail investors. Our tax advisors can worry about the after-the-fact computations.

      Regarding your comment about a major correction: There are ways of circumventing concerns of a major correction:

      1- Buying protective puts

      2- Put a “buy limit order” on the call and an “OTO” order to sell the stock. Or have your brokerage notify you when the call is bought back.

      Since we are commited to our positions one month at a time, we have plenty of time to avoid major losses in an unusual market environment. Since we all have different risk tolerances, there is no one best way to best manage markets like we had in 2008. Fortunately these are few and far between.

      To sum up Marty, you are missing nothing. You simply took an after-the-fact mathematical view of the trades and I walked through the process step-by-step.

      I appreciate the question because I think it is worthwhile re-stating the BCI philosophical and mathematical approach to covered call writing.

      Alan

  4. Barry B March 18, 2012 1:11 pm #

    Premium Members,

    The Weekly Report for 03-16-12 has been uploaded to the Premium Member website and is available for download.

    Best,

    Barry and The BCI Team

  5. Mike March 18, 2012 1:36 pm #

    Alan–

    I love your articles and the latest” Using multiple strategies….” is great.

    I use a somewhat for me more intuitive and simplistic calculation and get different results. I kept the stock and option trades separate and ignored the buy down. Could you point out my error.

    You bought 300 shares @73.73 or 22119
    You sold 3 contracts @ 5.82 or 1746

    The stock rises to 78.05 or 23415

    The option rises to 8.40 or 2520

    So– after you sell the stock you make 23415 – 22119 = 1296

    After you buy back the option you lose 2520 – 1746 = – 784

    So you sold the stock for 23520 ,but lost 774 on the buy back of the option, and you net 22746

    Where am I wrong?

    Thanks for all your help. You have made me an option lover.

    Mike

  6. Alan Ellman March 18, 2012 4:24 pm #

    Mike,

    Are you related to Marty (#3)? Both of you have excellent math skills and look at the trade from a completed perspective. Note that you and Marty both come to the same profit of $522 ($784 in your question should read $774):

    $1296 – $774 = $522

    The unique aspect of the BCI methodology is that we base our decisions on the information at hand every step of the way. This allows us to make the best investment decisions and increase our profits to the highest possible levels.

    Keep up the good work!

    Alan

  7. Steve Z March 18, 2012 5:38 pm #

    Alan, looks like we’re all trying to think through the profitability of these trades. As a way to simplify for my own trades each month, I make the assumption that I close all the trades and then do the return calculations.

    If you did that, i.e., if you assumed you closed the RAX trade on 3/15 rather than rolling out, then with that assumption I come up with you made $522 on the TPX trade and $1012 on the RAX trade for a total of $1534. Since the average risk was about $23,000, that’s about a 6.7% return for the month. Pretty impressive!

    • Alan Ellman March 19, 2012 3:42 pm #

      Steve,

      I liked that one too. I had a few last month. However, not all trades produce these results but many do. The main point is that being prepared with these exit strategies we can put ourselves in a position to generate additional cash for very little time and effort. Once educated and organized, hundreds and thousands can flow into our accounts that others will never realize.

      Alan

  8. Alan Ellman March 19, 2012 7:06 am #

    Running list stocks in the news: HLF:

    HLF has reported 4 consecutive positive earnings surprises at an average of over 16%. Earnings expectations for 2012 is 10% and for 2013, 13%. Propjections have been strengthening over the past 90 days. In the past year HLF has outperformed the S&P 500 by 67%; by 23% in the past 3 months and by 14% in the past month.

    Our premium watch list shows an industry segment rank of “B”, a beta of 1.09 and a dividend % yield of 1.30.

    Alan

  9. Alan Ellman March 19, 2012 3:44 pm #

    Early exercise of options:

    Here’s an offsite Q&A I thought may be of interest to our newer members:

    A question, I sold 2 IBM MAR12 200 calls during the last month, the price of IBM closed above 200 at least 2 times during the past week. Why didn’t my account reflect my IBM shares being called away until this morning(3/18)? If I’m missing something let me know. I find the sale of covered calls an interesting way to generate more gains from stock that would otherwise just sit.

    My response:

    An option will NOT automatically be exercised when the stock price moves above the strike price because there is usually time value left on the option premium. For example, if IBM traded @ $201 mid-week and the premium for the $200 call was $2, that option will NOT be exercised. The option holder can profit by $1 by exercising but can profit by $2 by selling the option.

    If the price ends the contract period above the strike, even by $0.01, it WILL be exercised on the Saturday after expiration Friday.

    Best,
    Alan

  10. Alan Ellman March 20, 2012 5:49 am #

    Running list stocks in the news: ASNA:

    On March 1st ASNA reported a 21% earnings “beat”, the 5th positive surprise in the past 6 reports. It trades @ 15x forward earnings below its industry peers average of 18.4x. Our premium watch list shows an industry segment rank of “A” and a beta of 1.25. Analysts have been raising estimates for 2012 as the company has been showing continuing growth strength. See the chart below for these growth estimates (click on chart to enlarge and use the back arrow to return to blog):

  11. Barry B March 20, 2012 1:01 pm #

    Premium Members:

    This week’s Weekly Stock Screen And Watch List has been revised and uploaded to The Blue Collar Investor premium member site and is available in the “Reports” section. The Running List section has been modified…PCLN is now in BOLD to agree with the left side of the page. Look for the report dated 03-16-12-RevB. The change was a minor typo and did not impact the results.

    For your convenience, here is the link to login to the premium site:

    https://www.thebluecollarinvestor.com/member/login.php

    Best,

    Barry and the BCI Team

  12. Pat March 20, 2012 1:52 pm #

    Alan,

    Since we are in a 5 week contract is it best to wait until next week to enter our new positions or is it okay to enter this week? Thanks for your help.

    Pat

    • Alan Ellman March 20, 2012 4:55 pm #

      Pat,

      In a 5-week contract I like to enter my positions within the first 7 trading days or time value erosion will impact our bottom line significantly. Any time this week is okay or the first two days of next week.

      Alan

  13. Suresh March 21, 2012 7:56 am #

    Great Article, Alan. Thanks

    Being an eager beaver, I entered (paper trading) CMI ITM CC, buying the stock at $127.42 and short calls strike of $125 generated $5.28, giving me the cost basis of $122.14.

    My plan was to roll the call when the stock violates my cost basis. It only took a day for CMI to test $122.

    I have rolled the short call to strike $120, generating additional $2.56.

    This is as far as my plan goes and it is now exhausted. If you were in my shoes, what would you do if the stock continues to move down, of indeed, if it shoots up again?

    Many thanks
    S

    • Alan Ellman March 21, 2012 5:55 pm #

      Suresh,

      Paper trading is a great way to get started. There is nothing like real-life experience to hone your skills before risking your hard-earned money.

      In my books and DVDs I discuss the “20%/10% guidelines” which provide a framework as to when to close the short options positions. At that point you can roll down, sell the stock or plan to “hit a double” or sell the same option if the stock price rises. These decisions are based on time to expiration, market tone and chart technicals. Much more detailed information is found in my second book (“Exit Strategies…”) and on pages 245 – 302 of “Encyclopedia….”.

      Let us know how you’re progressing with your paper-trading.

      Alan

  14. Fran March 21, 2012 9:31 am #

    Alan,

    Does your goal of 2% – 4% go up when there is a 5 week contract like the April contract?

    Fran

    • Alan Ellman March 21, 2012 5:57 pm #

      Fran,

      No. The additional week does not provide a significant percentage increase in premium generated but does give us a bit of flexibility as to when we enter our positions.

      Alan

  15. Robert March 21, 2012 11:39 am #

    Alan,

    I attended one of your seminmars last year and remember you telling us that you do most of your trading mid-day. Can you remind me of the trading hours and reasons.

    Thanks,
    Rob

  16. Alan Ellman March 22, 2012 5:44 am #

    Rob,

    I do most of my trading between 12PM and 3 PM EST to avoid early morning and late afternoon volatility caused by automated computerized institutional trading. The exception is when I’m rolling my options which I execute as close as possible to 4 PM EST on expiration Fridays.

    Alan

    • Steve Z March 22, 2012 3:57 pm #

      Alan, would you say more about the impact of trading before noon. I’ve heard lots of people say to avoid the first 30 minutes but hadn’t heard waiting that long. What are the negatives to trading during hours of high volatility? I might have thought it would present an opportunity for a good fill.

      Also, do you wait until the last minute on expiration Friday to maximize time decay? With the volatility at that time, seems like you also might get a bad fill and lose more than you’d gain with the last couple of hours of time decay.

      Steve

      • Alan Ellman March 22, 2012 4:30 pm #

        Steve,

        It may seem like I’m nitpicking but I try to maximize EVERY potential advantage available to us:

        1- You are correct that the worst hours to trade (for conservative cc writers) are 9:30 AM – 10:00 AM and 3:30 PM to 4 PM EST. These are the times of the highest potential volatility.

        2- Since many economic reports are reported @ 10AM, I push the start time forward a bit more (11 AM is okay but I publicize my “sweetspot” as 12PM EST).

        3- When the market is highly volatile and members are “legging-in” there may be an unfavorable movement in the option price after the stock purchase (I know…nitpicking). I got “hit” a few times early on in my cc career so I share this concept with our BCI community.

        4- If it is convenient for me to roll my options on expiration Friday I will start the process at about 2PM EST. The advantages of doing so are twofold. First, the time value to close has declined to about $0.05 while the longer term option has not eroded. Also, I can watch the share value as it relates to the strike price and there may be situations when I don’t have to roll the option at all if the price moves below the strike.

        5- If it is inconvenient for me to trade on Friday afternoon, I have no problem trading Friday morning or even Thursday.

        6- Some of the guidelines and rules in the BCI methodology will have a major positive impact on our bottom line results; others a minor one. If it’s a profit, I’m in!

        7- Back to the 12PM – 3PM trading time: I was fortunate to tour the floor of the NY Stock Exchange last year with my son Craig. I can tell you first hand that the market makers were more interested in their “big salads” and diet cokes than their computer screens in the early afternoon. Here’s Alan and Craig on the floor of the NYSE:

        • Steve Z March 22, 2012 4:33 pm #

          Excellent perspective. Thanks!

  17. Alan Ellman March 22, 2012 4:01 pm #

    Premium members:

    This week’s 6-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site.

    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

  18. Alan Ellman March 23, 2012 6:08 am #

    Running list stocks in the news: LULU:

    On our premium watch list for 5 weeks LULU reported another positive earnings report yesterday. Net revenues rose by 51% driven by a 26% increase in same store sales. Sales surpassed the $ 1 billion mark for the first time in fiscal 2011. Earnings per share was up 34% year-to-year and operating income rose by 63%. Our premium watch list shows an industry segment rank of “A” and a beta of 1.37. All this positive news has resulted in bullish growth projections for 2012 and 2013 as shown on the chart below (click on chart to enlarge and use the back arrow to return to this blog):

    Alan

    • Nancy March 23, 2012 8:42 am #

      Alan,

      It looks like the April itm and otm options generate 3% and the itm (72.50)- 2%. Am I reading this right? Thanks.

      Nancy

      • Alan Ellman March 23, 2012 9:15 am #

        Nancy,

        As of 10:10 AM for April calls:

        $72.50: 2.2% with 4.3% DP

        $75: 3.5% with 1% DP

        $77.70: 2.9% with 2.3% UP

        Note that at-the-money or near-the-money strikes always generate the highest intial returns. Now you must decide if you want additional downside protection or upside potential.

        Alan

  19. Lyle Bighley April 10, 2012 11:22 am #

    Alan–
    I have some naive questions regarding exit strategies. I bought Cummins Inc. (CMI) on March 19, 2012 for $127.77. On the same day I sold a covered call for April 21, 2012 at a strike price of $130. The premium was $2.69. On April 10, 2012 the price had dropped to apprxomately $114.75. Should an exit strategy be used in this situation? If an exit stratey is evaluated do we use the “What Now?” tab? Or is the better alternative to wait until expiration Friday and then sell CMI? An alternative would have been to have bought to close the position and then sold the underlying stock when it was down 8-10% below my purchase price. I would appreciate your insight into the analysis of this situation. Thank you.

    Lyle

  20. Alan Ellman April 10, 2012 12:44 pm #

    Lyle,

    Your question is not naive but rather critical and pertinent to mitigating losses and maximizing profits. Let me respond in general terms to a declining underlying equity. I will always close my short options position when the premium value falls to 20% of the original price in the first half of the cycle and to 10% in the beginning of the second half of the cycle. At this point you are free of any options obligation and maintained 80% – 90% of your original option profit. Now we must deal with a falling stock. Your choices are:

    1- look to “hit a double”
    2- roll down
    3- sell the stock

    The decsion is based on several factors:

    1- time to expiration
    2- market tone
    3- stock technicals
    4- company news

    If you did not take action and should have, view it as a learning experience and so it will be a valuable experience. Most covered call writers never take action prior to expiration Friday so in the long run you will have more success than most. See chapter 10 in “Encyclopedia….” or my book on exit strategies for more detailed information.

    Alan

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