Dr. Alan Ellman | Sep 11, 2016 03:15AM ET
Understanding option calculations is a necessary skill to become an elite covered call writer. The Ellman Calculator will do all the legwork but accurate and meaningful results are dependent on appropriate inputs. To highlight this point, let’s look at a real-life trade sent to me by Catherine who trades on the Toronto Stock Exchange:
Catherine’s trade
Why these stats make no sense
Let’s start with our basic premium equation:
Total premium = time value
Now, if the above stats are accurate, the $58.00 call generated $2.10 while BNS traded at $61.75 This cannot be because there is $3.75 intrinsic value + a time value component (with 8 months remaining to expiration) so a premium of $2.10 is impossible. I would expect a premium well over $5.00 depending on the implied volatility of BNS. I’ll bet most of you have figured this out.
I checked back with Catherine and sure enough the shares were purchased at a $61.95 but the covered call was sold after share depreciation to $58.00. Let’s say Catherine bought BNS 10 years ago for $5.00 per share which has now appreciated to $58.00 and then the $58.00 call was sold for $2.10. Does that mean her return for the 8-months remaining is 42% using a $5.00 cost basis (hint: rhetorical question)?
What is our cost basis when we write a covered call?
Tax issues aside, our cost basis is the price of the shares at the time the call is sold. Although Catherine paid $61.95 for the shares initially, the day the call was written the shares were worth $58.00. Had she paid $30.00 initially, the shares would still be worth $58.00 for purposes of covered call calculations. We cannot cloud our calculations by using irrelevant figures that have nothing to do with current positions.
Initial returns using current cost basis
The Ellman Calculator shows an initial 8-month return of 3.6% and a breakeven of $55.90. This annualizes to 5.4% which doesn’t get me very excited. It does, however, demonstrate the value of accurate calculations which will guide us in making the best covered call writing decisions in a given point in time.
Buying back the option when share price is at $62.00
The cost-to-close (buy back the option) is $5.75 which will move share price from the original $58.00 strike ceiling to current market value of $62.00. We have a share price credit of $4.00 and an option debit of $5.75 resulting in a net loss of $1.75 or 3% of our real current cost basis. This may be something to consider to get out of this “deal” and start using the cash for more productive investment trades. Lesson learned.
Discussion
Although the Ellman Calculators (and others) do the heavy mathematical lifting for us, inputting accurate statistics will result in meaningful calculations which will go a long way in guiding us to appropriate trades that give us the greatest chance of achieving high levels of success.
Market tone
Global declined this week on growing concerns that the accommodative monetary policy has reached the limit of its effectiveness and interest rates will be increasing in the near-term. The Chicago Board Options Exchange Volatility Index (VIX) rose to 17.5 from 12.11 last week, most of the increase occurring on Friday. Crude oil prices advanced on the week, with West Texas Intermediate crude rising to $46.50 per barrel from $44.00. This week’s reports and international news of importance:
THE WEEK AHEAD
For the week, the S&P 500 declined by 2.39% for a year-to-date return of +4.10%.
Summary
IBD: Uptrend under pressure
GMI: 6/6- Buy signal since market close of July 1, 2016 (prior to Friday’s decline)
BCI: Friday’s 2+% market decline does not imply a trend and it is important not to react emotionally. It may turn out to be a smaller version of the Brexit decline and rapid recover. I am managing my September positions and will decide on a ratio for the October contracts as next week’s action dictates.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The charts continue to point to a neutral outlook. In the past six months the S&P 500 rose by 7% while the VIX declined by 5%, stats that have been muted by Friday’s price action.
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