Evaluating The Success Of Our Covered Call Trades
Dr. Alan Ellman | Aug 05, 2018 01:31AM ET
Whenever a covered call trade results in a maximum return, it is a successful trade…period…end of story. To most, this statement appears nonsensical and self-evident. But I’m here to tell you that there are a lot of covered call writers that question that success. In late December 2017, Paul shared with me a series of trades he executed that resulted in a return that left him a bit discouraged. There were several components to his trades, but we will focus on the final trades:
Paul’s trades
- 11/16/2017: Long 800 SPDR S&P 500 (NYSE:SPY) at $258.91
- 11/16/2017: Sell (short) 8 x $255.00 12/15/2017 at $5.44
- 12/8/2017: (1-week prior to expiration) SPY was trading at $265.05
- 12/8/2017: $255.00 call was trading at $10.33
- 12/8/2017: Paul wanted to avoid exercise and was considering closing the short calls
Calculations when entering the trade
Since an in-the-money strike was sold, we know that there is no opportunity to enhance returns via share appreciation. Let’s feed this information into the Multiple tab of the Ellman Calculator :
The initial time value return when entering the trade was 0.6% (yellow field) with no opportunity for additional profit (brown field). There was a 1.5% protection of that initial time value profit. The trade goal had been defined upon entering the trade. No matter how high the share price rises that goal of 0.6% for the 1-month has been realized.
What about the cost-to-close if we want to retain our shares?
Initially, it would appear that the cost-to-close the short call ($10.33) is quite expensive especially when compared to the initial $5.44 premium received. However, we must view this cost through the lens of share value as well. When the $255.00 call was sold, the price of SPY could never be worth more than that strike price while the contract obligation was in effect. If the call is bought back (buy-to-close), share value rises to current market value or $265.05, an increase of $10.05. This means that the actual time value cost-to-close is only $0.28 per- share ($10.33 – $10.05). Since this evaluation took place a week prior to contract expiration, waiting another week would result in an even lower time value cost-to-close.
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What if Paul bought back the short call to avoid exercise?
On 12/8/2017, to close the short call would cost Paul $10.33, $10.05 in intrinsic value and $0.28 in time value. The time value cost-to-close is 0.11% ($0.28/$255.00). A lower cost-to-close would be achieved if we wait closer to contract expiration.
Discussion
Certainly, Paul would have generated a higher return not having sold the option. However, it never makes sense to look back on a trade and feel that more money could have been generated if a different strategy was used. We all would have made a fortune if we used the lottery numbers on Friday’s ticket purchase with the numbers we read in the newspapers on Sunday. Paul managed this trade to perfection given the following assumptions:
- His goal was about 1/2% per month
- He was bearish or concerned about the market and wanted the protection of an in-the-money strike
I’m going with those assumptions so congratulations Paul on achieving maximum returns.
Market tone
This week’s economic news of importance:
- Pending home sales June 0.9% (-0.5% last)
- Employment cost index Q2 0.6% (0.7% expected)
- Personal income June 0.4% (as expected)
- Consumer spending June 0.4% (0.5% expected)
- Core inflation June 0.1% (as expected)
- Case-Shiller home price index May 6.4% (6.4% last)
- Consumer confidence index July 127.4 (127.0 expected)
- ADP employment July 219,000 (181,000 last)
- Markit manufacturing PMI final July 55.3 (55.4 last)
- ISM manufacturing index July 58.1% (59.5% expected)
- Construction spending June -1.1% (0.2% expected)
- FOMC announcement 1.75 – 2% (as expected)
- Weekly jobless claims 7/28 218,000 (220,000 expected)
- Factory orders June 0.7% (as expected)
- Nonfarm payrolls July 157,000 (195,000 expected)
- Unemployment rate July 3.9% (as expected)
- Average hourly earnings July 0.3% (0.2% expected)
- Trade deficit June -46.3 billion (-46.6 billion last)
- Markit services PMI July 56.0 (56.2 last)
- ISM non-manufacturing index July 55.7% (58.6% expected)
THE WEEK AHEAD
Mon August 6th
- Survey of consumer expectations July
Tue August 7th
- Job openings June
- Consumer credit June
Wed August 8th
- None scheduled
Thu August 9th
- Weekly jobless claims 8/4
- Producer price index July
- Wholesale inventories June
Fri August 10th
- Consumer price index July
- Core CPI July
- Federal budget July
For the week, the S&P 500 moved up by 0.76% for a year-to-date return of 6.24%
Summary
IBD: Market in confirmed uptrend
GMI : 5/6- Bullish signal since market close of July 9, 2018
BCI: Using an equal number of in-the-money and out-of-the-money strikes. Impact of tariffs/trade wars unclear.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a bullish tone. In the past six months, the S&P 500 was up 8% while the VIX (11.69) down by 70%.
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