Covered call writers know how important exit strategies are to our ultimate success. Position management skills must be activated when share price rises or falls dramatically and when dividends become an issue or when a strike is in-the-money as expiration of the contract nears. Using our 20%/10% guidelines assist us in defining when to close our short positions (options) as stock price falls but then what?
When our short options positions (called short because we sold the option) are closed and we no longer have an option obligation, the next step is determined by factors detailed in my books and DVDs such as time to expiration, overall market assessment, chart technicals and personal risk tolerance. In this article we will focus in on a situation that challenges so many covered call writers: when do we sell our stock after closing the options positions due to a price decline? The task of making this decision is quite imposing for most retail investors for two reasons:
1- These stocks that have “let us down” were, in fact, great-performers recently. They’re bound to recover…right? Absolutely, just like Bear Stearns, Enron, Tyco and WorldCom (he said sarcastically). Cynicism aside, it’s understandable why so many of us hold out hope for such a security that has performed so well prior to the current contract month.
2- I respectfully submit that there is also a psychological component in play here as well. Nobody likes to take a loss and it’s not a “realized” loss until we sell the shares. So we tell ourselves that price recovery is right around the corner (did I mention Bear Stearns…). We’ve all experienced these feelings, especially me (years ago). We must train ourselves to react in a non-emotional manner.
Stock price is declining and we close our short options position…now what?
We must check for news updates related to the company. A reliable FREE site for accessing stock news is:
If the news is egregious like corporate fraud or the loss of a key contract, we must close our long stock position and use the cash to enter a new covered call trade. Yes, realize the loss and move on.
Now for the key aspect of this article
When there is no news available to explain the decline, I compare the price action of the security in question to that of the S&P 500. If the stock is significantly under-performing the overall market, realize the loss and exit the trade. If not, rolling the option or waiting to “hit a double” are two strategies still in play.
Real life examples
Four of the stocks on our premium Stock List dated 12-19-14 were:
All four experienced price declines during the January contracts and began dropping off our weekly ‘running list” Below is a 1-month price chart of these four securities and that of the S&P 500:
The S&P 500 is the black line, 3rd from bottom
AMBA: Brown line never broke below the S&P 500 so I’m more likely to stay with this stock
AVGO: Mirrored the S&P 500 (very slight dips below) and then moved above it in early January. Here, I’m also more likely to keep this security
AMGN and BIDU (purple and blue): Both securities under-performed the overall market for the entire contract month. If we reached the 20%/10% threshold, I am more likely to realize those losses and use the cash generated from the sale of the stock to move into a new covered call trade.
We are most likely to close our long stock positions when the 20%/10% thresholds are approached and either there is negative news reported that makes this a dangerous position to stay in or the security is under-performing the overall market. No one approach will generate positive results 100% of the time but we, as Blue Collar Investors, constantly strive to follow rules and guidelines that will dramatically throw the odds in our favor as we weed out the Enrons of the world.
Next live seminar:
February 6, 2015
The World Money Show Orlando, February 6, 2015 at The Gaylord Palms
Friday February 6th
4PM – 6PM
(I am an invited speaker. The Money Show is charging an admission fee to attend).
Alan’s article published in the January edition of the AAII Journal
Kudos to Barry Bergman, BCI Director of Research
(Letter from a coaching student):
- According to the Commerce Department, US housing starts increased by 4.4% in December to an annualized rate of 1.1 million units
- Sales of previously-owned home were also up by 2.4% in December, a 5.04 million units annualized pace
- Sales of previously-owned homes were up 3.5% year-over-year
- The median price of all existing homes in December came in at $209,500, 6% higher than a year ago
- The Conference Board’s Leading Economic Index (LEI) was up by 0.5% in December, the 15th gain in the past 17 months. This beat analyst expectations by 0.2%
For the week, the S&P 500 rose by 1.6%.
IBD: Confirmed uptrend
GMI: 4/6- Sell signal since market close of January 6, 2015
BCI: Cautiously bullish but selling an equal number of in-the-money and out-of-the-money strikes as a hedge against recent market volatility
Wishing you the best in investing,
Alan ([email protected])
Good evening Alan,
Kindly let me know if you have a watch list for cash secured puts and one for covered calls. Also, do your list include ETFs as well?
Thanks in advance!
Our watch lists are geared to selling short-term options on elite-performing securities. These apply to both calls and puts since we want our underlying securities to perform in the same manner for both strategies. I use the same watch list whether I am selling calls or puts.
We do have a separate watch list report for ETFs that is published mid-week. On average, there will be 20 – 25 eligible ETFs and 40 – 60 eligible stocks.
Thanks for your interest.
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 01/23/15.
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:
Since we are in Earnings Season, be sure to read Alan’s article, “Constructing Your Covered Call Portfolio During Earnings Season”. You can access it at:
Barry and The BCI Team
FYI == about 10% of your male readers cannot use the chart you show – 10% of males are red/green color blind and cannot tell red from brown or green and blue from purple.
Use dots and triangles etc on the lines to help those of us with this problem. Thank you
Thanks so much for reminding me of this. I use arrows in our ETF Reports for this very reason. I have updated the report to accommodate all those with this issue.
Keep an eye on me to make sure it doesn’t happen again!
Hi Alan…Great article this week. This is my biggest problem in investing, by far. When to get out of a position has been my achilles’ heel the past 20 years. I joined BCI precisely because it is something you are willing to discuss and help create disciplines / rules to address the exit strategy.
I love the AMBA chart above because it shows us a number of things, even in this simple one month price snap-shot: it does not penetrate the SP500 reference, it actually moves aggressively higher on Jan 6 when the SP500 and others moved lower (counter trend rally), it exhibits a lot of volatility which is a key ingredient for high time premium in a call option contract. In fact, the Feb 20 call with 60 strike, which is over 5% OTM, provides a $1.85 time premium, which would be a 3% return for 30 days. It takes such high volatility to generate that kind of return, OTM.
But when to sell such high vol stocks? They move up and down a lot (by definition), so a price decline, even as much as 15% as exhibited between Jan 12-15 (3 trading days!!) would not necessarily be a signal to sell. Such a challenge. I look forward to further learning with you.
There is no way we can guarantee a successful trade with every position in our portfolio. This applies to everyone including me and the screaming TV gurus. However, there is so much we can do to throw the odds dramatically in our favor. By screening fundamentally, technically and for common sense principles (earnings reports etc.) and having our arsenal of exit strategies in place, we are doing way more than everyone else.
There is no free lunch but education, motivation and due-diligence will always pay off in the long run.
A question on closing a position. If a covered call goes into the money early in the cycle do you hold and wait for the expiration week to adjust, or do you feed in the numbers into the calculator to decide to roll out/up early? Thanks!
The main strategy we look at when strike price moves deep in-the-money early to mid-contract is the mid-contract unwind exit strategy (pages 264 – 271 of the Complete Encyclopedia…). They is for the time value component of the option premium to approach zero before closing the entire position. You would use the “unwind now” tab of the Elite Calculator. If the time value is still significant, we take no action.
Thank you for this (the original blog entry, this question and the answer). This has been bothering me for a while. I recently read about the 20%/10% rule but I’ve been struggling to figure out if/when I should be selling a stock.
I think this is like the analogy of a frog in a pot of water that is slowly brought to boiling point – i.e. you should jump out when the water is lukewarm… not boiling! I have been burned a couple of times myself and I’m still learning.
What I took away from this blog entry and related comments is that unlike the 80%/10% rule for when to buy back the option there is no similar cut and dry rule for selling the stock… there is just more to it, and the S&P500 comparison above is probably just one of several strategies. I guess what it comes back to is that you need to do a gut check and ask yourself… based on what I see right now, would I go long this stock? Not long forever but what are the prospects for this stock for the next couple months? How long am “I” comfortable tying up this capital by waiting for the stock to recover and then compare this to how long I think it would take me to recover the loss with a better stock/option position. If the stock is truly ‘dead Jim’ (Star Trek reference) then you just have to bite the bullet, take the loss and move on.
The thing that I have noticed for myself is that it is really really hard to do this (i.e. take the loss). I have done it but it is hard. Or, if I decide to just let the option expire and wait it out (and I am like 15%+ below my cost basis) then I get tempted to write some covered calls below my costs basis in an effort to help lower my cost basis and recoup the loss. I have done this a couple times and dug myself out of a hole but it felt risky (and took a long time) so instead I have just waited for the stock to recover. I suppose in some instances this would be an ‘ok’ way forward but ultimately it is probably better to have cut losses sooner.
Recently I did some more research here on BCI and ‘rediscovered’ rolling up and out and I think this is a way to combat this. i.e so what if the stock blows past the strike price (which is below my cost basis), just roll up and out. I have one position right now where I may try this to help me get back to my cost basis / breakeven.
Sorry for the long comment but thought I’d share this in case it helps someone else.
Thanks for sharing and describing your experiences on this topic…very valuable to the BCI community. When share value declines and meets the 20/10% guidelines we must either roll down or sell the stock (may look to “hit a double” early in a contract). Watching and taking no action is not one of our choices. I tend to sell when a security is under-performing the market. For those who want to set a percentile guideline, 8-10% below purchase price is reasonable.
Thanks for the ultra fast response Alan!
Not sure what website above is referring to.
This article was outstanding Alan. However, would you change your thoughts if either AMBA or AVGO had earning reports due in the following month; i.e., sell the stocks rather than hold thru the earnings report period?
When we enter a trade using a security with an earnings report projected for the following month we know that if the strike is ITM we will most likely “allow” assignment. If not, we will either hold through the ER and then write the call after the report passes or sell the stock.
If we institute a mid-contract exit strategy to generate additional income or mitigate losses we still take advantage of those opportunities and then deal with assignment/non-assignment issues at the end of the contract.
Listened to 20% 10% buy back strategy 1st half of contract 2half of contract ?? are we talking time here? how do you define the two halves? confusing
This information is detailed in the Complete Encyclopedia…. and DVD programs with examples.
Here’s a brief summary:
1st half- first 2 weeks of a 4-week contract or the first 3 weeks of a 5-week contract.
2nd half- week 3 of a 4-week contract or week 4 of a 5-week contract
Investors.com shows for VRX, 6 Green Lights:
But on the “Get IBD Checkup for VRX”:
Industry Group Rank (1 to 197) 47 (YELLOW)
Is Green Light on first page “Group RS Rating” different?
A bit confused from reading your books.
Years ago (before SmartSelect) we used the Stock Checkup. then IBD re-vamped its website and we found SmartSelect to be more reliable and a lot more user-friendly.
The Group RS Ranking in SmartSelect is based on a 6-month price-performance time frame. The Industry ranking in the checkup page uses multiple time frames which (as far as I know) is not shared with the public.
I am more confident and comfortable using the SmartSelect rankings but have no issues with those who opt for other screens.
Hi Alan, I’m back again after a nice New year break(hope yours went alright too), and so thought I would kickoff the year with a few chart analysis questions still with me. My questions are:-
1. If the price of a stock is channelling s/ways and I have bought at bottom of this channel, then can I sell OTM options that are maybe up to halfway up inside the channel, or should I still favour selling ITM options, no matter where in this price channel I bought the stock?
2. If at the start of last week of contract the S&P500 is at or falling from a resistance level, then may it not be better to close out any stocks that have already declined more than the breakeven value, or even if the decline is approaching the breakeven amount?
3. You say that we should only use daily charts, but I was wondering if I could also use the other hourly and weekly charts for just the S&P500 chart in each months analysis, but still use just the daily chart for the stocks as usual? (I thought I could access the market-tone better doing this)?
4. Also if I had 5 stocks that I was already trading with, then should I need to continuously always be checking over the charts of other stocks (off each weeks premium report), to see for any that have positive technicals – just in case I may need to quickly use them after employing either a MCU or DMCP exit strategy?
That’s a really helpful article and have saved it, I will have more to ask about some selling rules I thought of, but just wanted to get the above lot out there first. Thank you.
Glad you liked this article. My responses:
1- I am more likely to sell an OTM strike on a consolidating stock if the overall market is bullish. Also, if selling multiple contracts I may sell both OTM and ITM strikes and favor the one based on overall market assessment.
2- In the final week of a contract the time value will be approaching zero. If your market assessment is bearish for the last week, closing is okay. The problem is making accurate forecasts over the next one week…very difficult. The potential loss is not so much the time value but rather share appreciation should the market recover. Your degree of conviction regarding the bearish market will dictate closing or not.
3- I have always encouraged members to use any additional technical parameters they are comfortable with or even replace one or more of the ones I use. I have found (for me) the greatest success with the ones I share in my books/DVDs/blogs.
4- No need to continuously check for strong stocks. We do that for you with our weekly screens and reports. If you need a replacement stock mid-contract it won’t take you that long after accessing the most recent stock and ETF reports.
UPDATE ON STOCKSCOUTER…from the provider:
“…With respect to a new home for StockScouter, we are in dialogue with one company which we think will be a great partner for us. However, even if we reach an agreement with them in the near-term, because they are in the middle of a systems upgrade project it is very difficult to project when the scores will be available on their site. We’re exploring other alternatives as well and will definitely keep you posted on our progress…”
We have been treated very well by these guys. They have been sending us periodic updates so we can maintain the integrity of the BCI methodology.
This week’s 6-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.
For your convenience, here is the link to login to the premium site:
NOT A PREMIUM MEMBER? Check out this link:
Alan and the BCI team
Running list stocks in the news: EA:
Electronic Arts has been on our Premium Watch List for 11 weeks. In its recent earnings release, revenues came in at $1.428 billion well above the $1.275 billion projected. Earnings per share (EPS) was $1.22 compared to the $0.90 expected. Full year guidance in both areas were also raised. EA is in the Software industry currently ranked “B” Our premium Stock Report shows a beta of 1.30, weeklys available and adequate open interest for near-the-money strikes. The chart below shows the price pattern for EA since it earned its way onto our premium reports: CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO THIS BLOG.