Dr. Alan Ellman | Dec 04, 2016 12:14AM ET
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 WEEK AHEAD
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
: 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%.
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