20%/10% Guidelines: Calculating Cost Basis, Option Premium

Exit strategies or position management for covered call writing and selling cash-secured puts is one of the three required skills we must master to achieve the highest levels of success. One of the most important strategies we employ is the 20%10% guidelines which guide as when to buy back a covered call option:

• When option value falls to 20% or less of original sale price in the first half of the option contract
• When option value falls to 10% or less of original option sale in the third week of a four-week contract
• When option value falls to 10% or less of original option sale in the fourth week of a five-week contract

For example, if we sold an option for $2.00, we automatically buy it back when option price falls to $0.40 or less in the first half of a contract of to $0.20 or less in weeks three or four depending on contract length. This can even be set up as a limit order immediately after entering the trade.

Rolling out-and-up

Another exit strategy available to us is rolling-out-and-up when share price has accelerated above the strike price as expiration is nearing. In this scenario, we buy back the option and sell the next month higher strike price. The question now arises as to how to calculate our new cost basis and option premium as it applies to the 20%/10% guidelines in the upcoming contract month. To assist in understanding these concepts, let’s take a real-life example from the BCI Premium Watch List as of June-July, 2016:

Rolling out-and-up with Five Below Inc. (FIVE)

• Original option sale was for the June, 2016 $45.00 strike
• Share price as expiration approaches is $45.42
• Cost to close the $45.00 strike is $0.60
• Premium generated from the sale of the July, 2016 $47.00 call is $1.00

Calculating rolling-out-and-up returns using the “What Now” tab of the Ellman Calculator

The Ellman Calculator shows us that our initial return is 1.82% for one month. If share price moves up to the $47.00 strike, there is a potential one-month return of 5.33%. Once this position is established, what are our 20%/10% guidelines?

Calculating our new cost basis and option premium

Of the $0.60 spent to close the initial short call, $0.42 was intrinsic value which “bought up” the share value from $45.00 to $45.42. This leaves $0.18 of time value as our true cost-to-close. Our new cost basis for purposes of evaluating our current position is $45.42 and our net option premium for the upcoming month is $1.00 – $0.18 = $0.82. This can also be derived from the cell highlighted in brown in the Ellman Calculator spreadsheet.

Establishing our 20%/10% guidelines

This would make our 20% guideline $0.164 and $0.082, 16 cents and 8 cents. These are guidelines so I would estimate in the $0.20 range in the first half of the contract and in the $0.10 range in weeks three or four depending on contract length.

To simplify

Deduct the time value cost-to-close the near-month option from the next month premium to establish the option premium from which our 20%/10% guidelines are calculated. Or simply check the calculator cell “net return w/o upside potential”

Discussion

When establishing option premium amount for purposes of setting our 20%/10% guidelines after rolling out-and-up, we must deduct the time value cost-to-close the near-month short call from the next month premium. This stat can be gleaned from the “What Now” tab of the Ellman Calculator.

***On an unrelated note, have a look at what a disappointing earnings report did to this stock on Thursday 1/26/2017.

Market tone

Global stocks moved up, led by US shares, with the three most-important US indices — the Dow Jones Industrial Average, S&P 500 Index and Nasdaq Composite Index — all setting records during the week. West Texas Intermediate crude increased to $53.10 per barrel from $52.40. Volatility, as measured by the Chicago Board Options Exchange Volatility Index (VIX), fell to 10.58 from 12.4 last week. This week’s reports and international news of importance:

• US economy slowed in fourth quarter to an annualized pace of 1.9% in Q4 from the 3.5% reading in Q3.
• One bright spot in Friday’s US data releases was a third straight month of improved capital expenditures
• The Trump administration took a series of executive actions in its first week in office including approving the long-stalled Keystone XL and Dakota Access pipelines
• President Trump met with the CEOs of several manufacturing companies, including the Big Three automakers, and encouraged them to build new plants in the United States. Trump also met with union leaders
• The administration also announced it will nominate a replacement for Supreme Court justice Antonin Scalia on February 2nd
• Foreign trade, much discussed by candidate Trump, remains a major focus, with the new president this week threatening a 20% tax on Mexican imports
• The Dow Jones Industrial Average closed above 20,000 on Wednesday for the first time in its 120-year history
• Economically, Brexit has not been the disaster that pundits predicted. GDP grew by 0.6% in Q4, and by 2% for 2016 as a whole. On Friday, the prime minister became the first foreign leader to meet with President Trump, discussing a post-Brexit trade pact with the US
• A weakening yen and strong US auto sales in 2016 help boost Japan’s trade balance into surplus for the first time in six years
• While the Canadian government has not taken any final decisions on how it will approach the renegotiation of the North American Free Trade Agreement. Mexico is in a much worse bargaining position than Canada, so that it would not make sense to create a joint front against the US.

THE WEEK AHEAD

MONDAY, JAN. 30th

• 10 am Pending home sales Dec.

TUESDAY, JAN. 31st

• 10 am Consumer confidence index Jan.

WEDNESDAY, FEB. 1st

• 8:15 am ADP employment Jan.
• 9:45 am Markit manufacturing PMI Jan.
• 10 am ISM manufacturing Jan.
• 2 pm FOMC announcement

THURSDAY, FEB. 2nd

• 8:30 am Weekly jobless claims

FRIDAY, FEB. 3rd

• 8:30 am Nonfarm payrolls Jan.
• 8:30 am Unemployment rate Jan.

For the week, the S&P 500 was up by 1.03% for a year-to-date return of 2.50%.

Summary

IBD: Market in confirmed uptrend

GMI: 6/6- Buy signal since market close of November 10, 2016

BCI: I am currently fully invested and have an equal number of in-the-money and out-of-the-money strikes. From a purely economic perspective, I am concerned about the apparent nationalistic policies of the new administration in what is an unavoidable global economy. Despite all the bullish signals, I have a neutral to slightly bearish overall market assessment.

WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US

The 6-month charts point to a neutral to slightly bullish outlook. In the past six months, the S&P 500 was up 6% while the VIX (10.58) declined by 16%.

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