After entering our covered call writing or put-selling positions, we immediately prepare for possible exit strategy opportunities. All exit strategies begin by buying back the option, call or put. These position management techniques are used to mitigate losses, turn losses into gains and enhance winning positions to even higher levels. This is the reason we need to have a cash reserve in our brokerage account.
A reasonable guideline is to set aside between 2% – 4% of the portfolio value for potential exit strategy executions. Our main concern after selling covered calls or cash-secured puts is share value decline. When the stock or exchange-traded fund price declines significantly, buying back the option frequently will make sense. The cost to close short calls and short puts will differ dramatically and we must be aware of this disparity and understand they exist.
When stock price declines the cost to close calls decreases
Call options have positive Deltas in the range of 0 to +1. A call buyer benefits from share appreciation and therefore the option increases in value as share price accelerates and decreases in value as share value declines. If the call option holder bought a $30.00 strike and share price moves from $30.00 to $25.00, that right to buy at $30.00 becomes less valuable. If a covered call writer sold that option, the cost to buy it back (close the short call) would generally be lower than the price generated from the original option sale. These concepts are the basis of our 20%/10% guidelines for covered call writing.
When stock price declines the cost to close puts increases
Put options have negative Deltas and range from 0 to (-)1. A put holder benefits from share value decline and so put options increase in value as stock prices decelerate. If the put buyer bought the $30.00 put and share price moves down from $30.00 to $25.00, that put is worth much more. As put-option sellers, it would cost more to buy back that short put and there would be a net option debit cost-to-close. This means it would require more cash on hand to execute exit strategies resulting from share price decline for puts compared to the amount needed had calls been sold. These concepts are the basis of our 3% guideline for put-selling as detailed in my books and DVDs.
When stock price increases the cost to close calls increases
When share value rises, Delta moves option value higher as well. This is a positive scenario for option sellers. We may still want to close our short calls if the time value cost-to-close approaches zero. This is the basis of our mid-contract unwind exit strategy (detailed in both versions of The Complete Encyclopedia). By closing the short call there will be share appreciation from strike price to current market value which may incentivize executing this strategy. Again, there must be adequate cash in our brokerage account to initiate the mid-contract unwind exit strategy.
When stock price increases the cost to close puts decreases
Negative Deltas force put values lower as share price accelerates. Short put positions can be closed at a lower cost than the premium initially generated. This is the basis for our 20%/10% guidelines for selling cash-secured puts. When share value rises, the cost-to-close short puts is less than that for selling short calls.
Cost-to-close summary chart
Cost–to-Close Short Options
Discussion
Whether using covered call writing or selling cash-secured puts, a cash reserve of 2% – 4% is required for possible exit strategy opportunities. When share value declines, the cost to close short calls decreases whereas the cost to close short puts increases. When share value rises, the cost to close short calls rises and falls for short puts.
Market tone
Global stocks consolidated recent gains this week, while interest rates and oil prices both rose. An OPEC production cut was announced on Wednesday, helping push the price of West Texas Intermediate crude up to $51 a barrel from $47.50 a week ago. Volatility, as measured by the Chicago Board Options Exchange Volatility Index (VIX) moved up to 14.12 from 12.6 last week. This week’s reports and international news of importance:
- The US economy added 178,000 new jobs in November, in line with market expectations
- The unemployment rate dropped to 4.6%, the lowest in nearly a decade
- Average hourly earnings were disappointing, dropping 0.1% in November after rising 0.4% in October. Economists had expected earnings to rise 0.2%
- GDP was revised up for the 3rd quarter to an annual rate of 3.2%
- After-tax corporate profits advanced a robust 5.2%, the first rise since late 2014
- Solid recent economic data, combined with reflation hopes in the wake of the US election, have pushed US yields significantly higher in the past several weeks. To illustrate the point, the Bloomberg Barclays Global Aggregate Bond Index (NYSE:LD) suffered the worst monthly loss in its history in November, declining 4%
- Manufacturing purchasing managers’ indices have been showing a broad global turn for the better in recent months. November data showed sizable gains, with PMIs in the US, China and the Eurozone all exceeding forecasts. The Institute for Supply Management’s US manufacturing PMI was particularly robust, rising to 53.2 from 51.9. A reading above 50 signals that the sector is expanding
- A referendum on constitutional reform takes place in Italy this Sunday. Prime Minister Matteo Renzi has vowed to resign if the referendum goes down to defeat. Polling ahead of the vote suggests the referendum won’t pass, though there are still a large number of undecided voters. A defeat would add momentum to the anti-establishment mood among voters in both the US and Europe
- Austrians return to the polls on Sunday to vote in a long-delayed presidential election between Alexander Van der Bellen, a Green who is running as an independent, and Norbert Hofer of the populist People’s Party. Van der Bellen won a close contest in May, but voting irregularities forced Sunday’s rerun. The stability of the European Union could be called into question if anti-establishment momentum continues to build ahead of key federal elections in the Netherlands, France and Germany in 2017
- Thursday, French president François Hollande, whose approval rating stands at just 4%, announced that he will not stand for reelection next year, becoming the first French president since World War II not to seek a second term
- OPEC leaders met this week in Vienna and agreed to cut production by OPEC members by 1.2 million barrels per day and by 600,000 barrels per day by non-members, including Russia. The deal is the first of its kind in eight years. OPEC hopes the agreement will result in a reduction in inventories over the coming months, which they hope will coincide with a pickup in demand
- President-elect Donald Trump announced he will nominate Steven Mnuchin as Treasury Secretary. Mnuchin is a former Goldman Sachs executive and hedge fund manager. Tax reform and reducing regulation are high on Mnuchin’s agenda
- Trump also nominated financier Wilbur Ross to serve as Commerce Secretary. Ross said increasing US exports will be his focus, along with negotiating favorable bilateral trade deals
- Economic growth in Europe looks to be gathering momentum as unemployment in the eurozone fell below 10% this week for the first time in seven years this week, to 9.8%
- In addition to a firm PMI, Germany reported the largest jump in retail sales in five years. Sales rose 2.4% in October compared with September
- The Case-Shiller National Home Price index this week eclipsed the peak it set in July 2006. From that peak to its 2012 trough, the index fell 27.4%. However, the recovery has been uneven across the US, analysts say, and point to median home prices still being about 20% below their 2006 peaks
- Facing massive protests as a result of a corruption scandal, South Korean president Park Geun-hye is under intense pressure to end her term early. On Tuesday, Park said she would resign if ordered to by the nation’s parliament
THE WEEK AHEAD
- Italy holds a constitutional reform referendum on Sunday, December 4th
- Austria holds presidential elections on Sunday, December 4th
- Service sector PMIs are released on Monday, December 5th
- The United Kingdom releases Q3 GDP figures on Wednesday, December 7th
- Japan reports Q3 GDP on Wednesday, December 7th
- The European Central Bank Governing Council meets to set rates on Thursday, December 8th
For the week, the S&P 500 declined by 1.00% for a year-to-date return of +7.20%.
Summary
IBD: Uptrend under pressure
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. Like the rest of us, the market is still trying to figure out how new economic policies will impact corporate bottom lines. I tend to favor defensive postures in these environments and that’s why I only established 50% of my December contract positions with out-of-the-money strikes.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a neutral outlook. In the past six months the S&P 500 was up 5% while the VIX also rose by 5%.