Exit strategies for covered call writing are essential for achieving the highest levels of success. In the BCI methodology, we have a series of guidelines that assist us in determining which position management techniques should be instituted and when we should consider them. Not taking appropriate action when responses to changes in our stock and option positions are required will significantly impact our final returns. But so too will over-reacting and executing more position management trades than necessary. In today’s article, I will highlight a real-life classic example of over-trading shared with me by a premium member. Let’s call him Alan (I like the name).
Alan’s trades:
- 7/11/2016: Buy AAPL at $96.67
- 7/11/2016: Sell the 8/12/16 $102.00 call for $0.76 (slightly less than a 1%, 1-month return with plenty of upside)
- 7/28/2016: AAPL is trading above $104 and Alan is concerned about early exercise
- 7/28/2016: Buy-to-close the $102.00 call for $2.49
- 7/28/2016: Roll out and up to the 9/16/2016 $105 call to generate $2.08
- 8/3/2016: AAPL was trading above $105.00 and an ex-dividend date due on 8/6/2016
- 8/3/2016: Alan is again concerned about early exercise
- 8/3/2016: Buy-to-close the $105.00 call for $2.73
- 8/3/2016: Roll out-and-up to the 10/21/2016 $110.00 call for $1.93
- 8/3/2016: Total trading commissions to date = $18.38
What’s going on here?
Alan’s goal is to generate cash flow by selling out-of-the-money call options but his main priority is not to have shares sold. Defensive trade executions occurred when the strike moved in-the-money and when there was an ex-dividend date approaching. These trades have resulted in a net debit on the option side and an extension of the option obligation two months out from the last trade.
What is the profit and loss to date?
These trades have not resulted in a financial disaster by any means. On the option side, there is a net debit of $45.00 per contract. On the stock side, there is an unrealized credit of $833.00 ($105.00 – $96.67) per contract. After deducting commissions, there is a 3-month unrealized profit of 8%, 32% annualized.
Exploring the details to better manage these trades
This series of trades was initiated on 7/21/2016, five days prior to an earnings report which was responsible for the “surprise” bump in price as shown in the screenshot below:
Alan’s ex-dividend date is valid but not a huge concern since the expiration date of the current option at the time (9/16/2016) was not close to the ex-date (8/4/2016). Early exercise in these scenarios are super-rare.
Concern for early exercise every time a strike dips in-the-money is also not a major concern until we closely approach 4 PM ET on expiration Friday. This is because the option holder generates intrinsic value only and leaves the time value component of the option premium “on the table”. Stated differently, the option holder would make more money selling the option prior to expiration.
How can we better manage trades like these?
We can break the answers into three categories:
Avoid earnings reports
Buy the stock after the report or if we want to own the stock long-term, write the call after the report passes. This will allow us to benefit from a positive report and then an out-of-the-money call more appropriate for the post-report market price.
Avoid ex-dividend dates
Write the call the day after the ex-date or write a 2-month call moving expiration much further away from the ex-date.
Master rolling strategies
We must have a firm understanding when and why early exercise may occur. It is extremely rare. Rolling is mainly for in-the-money strikes near expiration Friday and certainly not every time a strike moves in-the-money.
Discussion
I’ve certainly done my share of over-trading. I’ve never viewed these micro-management exercises as mistakes but rather as learning experiences that made me a better trader. The good news for Alan is that he has learned valuable lessons while still making a profit. I’ll bet that next time, Alan’s profits will be even higher than they are now.
Market tone
Global stocks extended gains this week as US corporations started the 4th quarter earning season with positive results. West Texas Intermediate crude dropped to $53 a barrel from $53.90 a week ago. The Chicago Board Options Exchange Volatility Index (VIX) was steady at 11.28. This week’s reports and international news of importance:
- US retail sales rose 0.6% in December, but were flat when excluding automobile and gasoline sales
- Exports from China fell for a second year amid continued weakness in global trade. The possibility of disagreements with the United States over trade does not brighten the outlook for
- The National Federation of Independent Businesses termed the jump in its small business optimism indicator “stratospheric” as the number of business owners who expect better business conditions jumped 38 points. The index rose to 105.8, its highest level since 2004
- The World Bank expects global growth to expand at a 2.7% rate in 2017, up from 2.3% in 2016, a post-crisis low
- President-elect Donald Trump held a press conference this week but did not lay out a clear framework for the tax cuts and regulatory reforms he campaigned on. Markets are growing concerned that stimulus could come later than expected or be smaller in size than first envisioned. Trump did say that the Affordable Care Act would be repealed and replaced “essentially simultaneously.” The president-elect said that he would place his business interests in a trust and transfer control of his company to his two adult sons
- The German economy expanded 1.9% in 2016, the fastest pace in five years, up from 2015’s 1.7% pace
- Bank of England governor Mark Carney said this week that Brexit is no longer the biggest single risk to financial stability in the United Kingdom
THE WEEK AHEAD
- MONDAY, JAN. 16
US financial markets are closed for Martin Luther King Jr.
- TUESDAY, JAN. 17
- The World Economic Forum in Davos begins
- Wholesale inventories
- WEDNESDAY, JAN. 18
- The United States reports consumer price data
- THURSDAY, JAN. 19
- The European Central Bank holds a rate-setting meeting
- Weekly jobless claims
- Federal budget Dec.
- FRIDAY, JAN. 20
China reports retail sales and gross domestic product figures
Consumer sentiment
Business inventories
For the first week in 2017, the S&P 500 dipped by by 0.10% for a year-to-date return of 1.60%.
Summary
IBD: Market in confirmed uptrend
GMI: 5/6- 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. I remain cautious as we enter another earnings season.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a moderately bullish outlook. In the past six months, the S&P 500 was up 6% while the VIX (11.28) declined by 15%.