When we write covered calls, our expectation is that if the strike expires in-the-money (ITM), even by $0.01, our shares will be sold at the strike price as a result of option exercise. We check our brokerage accounts the Saturday after expiration Friday and our shares are gone and our cash accounts have grown. This is the case nearly all the time, but there are some unusual circumstances when exercise of ITM strikes will not take place. Thanks to Brian K. for sharing his trade with KKR & Co Inc. (NYSE: KKR) which exemplifies such an aberration.
Brian’s KKR trade
- 2/29/2024: Buy 500 x KKR at $98.13
- 2/29/2024: STO 5 x 3/1/2024 $98.00 calls at $2.10
- 3/1/2024 (next day, expiration Friday): KKR trading at $98.83 at 4 PM ET, assignment expected
- 3/1/2024: Between 4 PM ET and 4:25 PM ET, KKR traded (on light volume) between $99.00 – $101.00
- 3/1/2024: Between 5:26 PM ET and 5:30 PM ET, KKR dropped to $95.50 – $96.00
- 3/2/2024: Checked brokerage account and shares not sold, option expired without exercise
- 3/3/2024: KKR opens at $96.50 and closed at $98.80
Analysis goals for this article
- Identify any red flags for trade entry
- Propose a possible explanation why exercise did not occur
Price chart red flag
- #1: Exponential moving averages are bullish (a big positive)
- #2: The MACD histogram tuned negative, a bearish signal
- #3: The stochastic oscillator dropped below the 80% and is descending, a bearish signal
- #4: Volume is robust, giving credence to the technical indicators
Calculation red flag
- Brown cells: This trade represents a 2-day return of 2.01%, 366.86% annualized
- Yellow cell: Breakeven price point at $96.03
- Green cell: Minimal downside protection (of the time-value profit) of 0.13%
An annualized option return of 366.86% tells us that there is extremely high implied volatility in KKR at the time of the trade, with market expectation of potential extreme price movement, either up or down, by contract expiration. Are we willing to incur this risk? For some of us, yes; for most of us, no. There is no right or wrong here, but we must identify the risk inherent in our trades before making final decisions on where we will place our hard-earned money.
Why was there no exercise?
At 4 PM ET on expiration Friday, we can no longer manage our trades. If a strike is expiring ITM, we can (almost) always expect exercise and assignment of our shares, even if the strike is ITM by only $0.01. In Brian’s trade, KKR was expiring $0.83 ITM at 4 PM ET, but no exercise. This is because market-makers have an additional (approximately) 90 minutes to notify the Options Clearing Corporation (OCC) if they want to pursue exercise. If there is expectation of negative news coming out after hours, causing share price decline by Monday morning’s market open, these ITM calls may not be exercised.
I researched KKR news at the time of the trade and found several articles regarding insider trading as potential explanations for the high implied volatility of KKR:
Discussion and lessons learned
- If we enter trades with huge annualized premium returns, the underlying securities have extremely high implied volatility and, therefore, high risk
- When covered call strikes expire ITM, even by $0.01, exercise will, typically occur
- In rare cases, ITM strikes will not be exercised, usually due to negative news or the expectation of negative news coming out after hours
- Market-makers (not us) have an additional (approximately) 90 minutes after-hours, to decide on exercise
Final outcome
Brian sold his shares on Monday (3/3/2024) at the breakeven price point, so no financial pain, with “free” information for future trades.
Poor Man’s Covered Call Calculator
The PMCC Calculator is designed to determine initial trade structure and status as well as various position management price point considerations and the exit strategy price buyback points to buy back the short calls based on the 20%/10% guidelines detailed in the BCI books and Online Video Programs. The spreadsheet comes with a user guide.
Cells are provided to enter the option month and current date, used to assist with the calculations. There are 5 tabs incorporated into this calculator. The image above shows the 1st tab for trade initialization.
Click here for more information and a detailed video.
Alan Speaking at The All Stars of Options Event in Las Vegas on Thursday
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Barry and The Blue Collar Investor Team
Alan,
I attended and learned a lot from your 2 hour class and panel presentation in Las Vegas. I especially liked your idea of a 20 -10 % limit order after entering a covered call trade.
I am unclear about how to do this for in the money strikes. Is it 20% of the entire premium or of the time value only?
Thanks a lot.
Gary
Gary,
Glad you enjoyed and benefitted from my presentations.
The 20%/10% guidelines apply to the entire premium. This relates to the impact Delta has on premium value as I spent several years of analysis in the 1990s to decide on these guidelines.
Alan
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This week’s 4-page report of top-performing ETFs, along with our sample trade of the week, has been uploaded to your premium site. The Select Sector SPDR section is now crafted to align with our streamlined (CEO) approach to covered call writing. The report also lists Top-performing ETFs with Weekly options, mid-week market tone as well as the implied volatility of all eligible candidates.
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Alan and the BCI team
Alan,
I would like to know if you would talk with me about advice on how to recover DELL cost basis 135 now that it is down to 95 where I normally do covered calls one step in the money on a short term weekly uptrend.
Either I hold and continue to sell calls to get 1% of the original share price a week above the underlying value with a nerve racking situation of picking the sell strike and possibly have to roll out up or down to not have shares taken away until the price maybe gets back up to 135.
Or I sell one step in the money below underlying value at 95 and allow the shares to be taken, but buy them right back and sell a covered call one step in the money again at 3 dollars a pop and buy the shares right back when taken away and would have to do this many many weeks to get up to 165 thereabouts in accumulated earnings to have the capital to pay the taxes and be left with the original 135 cost basis.
I wished I had learned about somehow setting a stop loss on covered calls. But the after hours limit requirements mess up the possibility of getting out shares if there were a gap down.
Respectfully,
Michael
Michael,
It’s the cash we have invested in the stock that matters, not the stock itself. When share price declines substantially, we ask ourselves if we would buy the stock at its current price with the information available?
If the answer is no, we sell the stock and use the cash to invest in a better-performer.
If the answer is yes, we can generate option premium + allow for share appreciation by selling deep out-of-the-money call options.
To avoid exercise and allow or maximum share price recovery, we use Delta or implied volatility to establish a high end of the trading range for the specific option contract we are considering.
For example, if we use a strike with a delta of 10, there is approximately a 10% probability that the strike will expire in-the-money (with intrinsic-value) and subject to exercise. We must be prepared to roll the option if this 10% risk comes to fruition.
Implied volatility calculations will result in approximate 84% probability of avoiding exercise risk.
Alan