What Criteria Should We Use To Close Our Covered Call Positions Early?
Dr. Alan Ellman | May 06, 2018 12:54AM ET
When we sell out-of-the-money call options , we are initiating bullish covered call writing positions. Our goals are to generate option premium as well as share appreciation from current market value up to the call strike price. When share value moves well above the strike, leaving that strike deep in-the-money, there is no opportunity to generate any additional profit in that trade. Our mid-contract unwind exit strategy involves closing both legs of the current trade and entering a new trade, with the cash generated from the sale of the stock, using a different underlying security. It is important to know how to evaluate when it is in our best financial interest to undertake this position management maneuver. In September 2017, Andrew shared with me a trade he executed where such an exit strategy decision was being considered.
Andrew’s trade
- 9/20/2017: By Ultra Clean Holdings Inc (NASDAQ:UCTT) at $27.90
- 9/20/2017: Sell the $30.00 Oct. 20th call at $0.77
- 10/11/2017: UCTT trading at $31.62
- 10/11/2017: “Ask” price to buy back the $30.00 call traded at $2.50
Initial calculations with the Ellman Calculator (click for free copy)
The initial return on the option sale (ROO) is 2.8% with the possibility of an additional upside potential of 7.5% if share price moves from current market value ($27.90) to the call strike of $30.00. There is a potential 1-month return of 10.3%
Cost-to-close mid-contract
It is critical to calculate the actual time-value cost-to-close which will be less than the “ask” price of $2.50 highlighted in Andrew’s trade. Since the sale price can be no more than $30.00 while the option obligation is in place, share value will rise to current market value of $31.62 if the option is bought back (buy-to-close). The “unwind now” tab of the Elite version of the Ellman Calculator, will deduct the intrinsic value component of the $2.50 premium and calculate the actual time value cost-to-close as shown in the screenshot below:
Get The News You Want
With 8 trading days remaining until contract expiration, our cost-to-close is 2.93%. We now ask ourselves if we can generate at least 1% more than 2.93% (3.93% or more) in the next 8 trading days?
Discussion
Generating 3.93% or more in 8 trading days is highly unlikely unless we use an extremely volatile underlying security. This makes little sense since we are employing one of the most conservative option strategies available. At this point in time, Andrew had an unrealized, 1-month profit of 10.3% with a downside protection of 5.4% (the 10.3% is guaranteed as long as hare value does not decline below $30.00). In this case, the best action is no action at all. As expiration Friday approaches, we can evaluate for the possibility of rolling the option makes financial sense.
Market tone
This week’s economic news of importance:
- Personal income March 0.3% (0.4% expected)
- Consumer spending March 0.4% (0.5% expected)
- Markit manufacturing April 56.5 (56.5 last)
- ISM manufacturing index April 57.3 (58.7 expected)
- Construction spending march (-)1.7% (0.5% expected)
- ADP employment April 204,000 (last 228,000)
- Weekly jobless claims 4/28 211,000 (225,000 expected)
- Trade deficit March (-) $49.0 billion (- $49.4 billion expected)
- Productivity Q1 0.7% (0.9% expected)
- Markit services April 54.6 (54.4 expected)
- ISM nonmanufacturing index 56.8% (58.0% expected)
- Nonfarm payrolls April 164,000 (184,000 expected)
- Unemployment rate April 3.9% (4.0% expected)
- Average hourly earnings April 0.1% (0.2% expected)
THE WEEK AHEAD
Mon May 7th
- Consumer credit March
Tue May 8th
- Job openings March
Wed May 9th
- Producer price index April
- Wholesale inventories March
Thu May 10th
- Weekly jobless claims through 5/5
- Consumer price index April
- Federal budget April
Fri May 11th
- Import price index
- Consumer sentiment May
For the week, the S&P 500 moved down by 0.24% for a year-to-date return of (-) 0.38%%
Summary
IBD: Uptrend under pressure
GMI : 3/6- Buy signal since market close of April 18, 2018
BCI: Selling 2 in-the-money strikes for every 1 out-of-the-money strike for all new positions. Decent jobs report confirming positive economic support.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a slightly bearish sentiment. In the past six months, the S&P 500 was up 0% while the VIX (14.77) moved up by 50%. The VIX has subsided a bit more from the last week.
Wishing you much success,
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