Writing Covered Call Options To Compensate For Share Depreciation

Covered call writing generates monthly (or weekly) cash flow but it also reduces our cost basis. The latter result is the reason why covered call writing increases our chances of a successful trade more so than simply owning the stock. Historical data tells us that in the long haul the stock market increases in value. In the short term…who knows? There are too many moving parts to accurately predict near-term stock movement consistently. The BCI methodology is based on a 3-pronged screening process and a requirement to master 3 skills:

• Stock selection
• Option selection
• Position management

Meeting these system requirements will not guarantee a successful trade in the near-term but it will throw the odds dramatically in our favor. This means that despite all our efforts, share price can move lower and into a losing position. So, is covered call writing an appropriate strategy for recovering these losses by reducing our cost basis? This article was inspired by Jacob K who shared his trade with me on February 8, 2017.

Jacobs trade and dilemma

• Buy 40,000 shares of Blackberry (TO:BB) at a cost basis of $9.40
• Stock currently trading at $7.25
• Unrealized share loss = $86,000.00
• Looking for a low-risk way to reduce cost basis to mitigate losses

Factors to consider

1- Is this part of a portfolio overwriting strategy where we want to hold these shares for the long haul despite price movement?

In this case we immediately turn to covered call writing that is tailored to this specific goal. We use only out-of-the-money strikes and circumnavigate around earnings reports as well as ex-dividend dates. If the strikes sold are in-the-money as expiration Friday approaches, we roll the options. See chapter 14 in both versions of the Complete Encyclopedia for more details on this strategy.

2- What if the stock is not necessarily a long-term hold?

This is where many retail investors fall into a trap including yours truly back in the day. The dangerous thinking here is that the $86,00.00 loss is not “realized” until we sell…so don’t sell. We know that share value will always come back just like WorldCom, Bear-Stearns, Enron, and Tyco…oops, were those bad examples? Let’s look at the chart of BBRY as of 2/10/2017:

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Note that the longer-term 100-d EMA (red arrow) is above the shorter-term 20-d EMA (blue arrow), a bearish short-term technical signal. Now, there are other factors to consider so this may still be a security we want to keep in our portfolio but it will make us all better investors if we give ourselves the flexibility of selling losers when appropriate (pardon the sarcastic Enron etc. references…I like to humor myself when I write these articles). The takeaway here is to remember that it is the cash we care about, not the stock that it is invested in.

3- Is there concern regarding assignment risk?

When we write a covered call (400 contracts in this case) there is always a chance of early assignment. That’s where two of the three required skills come into play…option selection and position management. We select out-of-the-money strikes that meet our monthly goals, circumnavigate around earnings dates and ex-dividend dates when applicable. BBRY does not distribute dividends as of the writing of this article. Should share price move above the (originally) out-of-the-money strike, we must roll the option prior to 4 PM ET on expiration Friday.

Discussion

Covered call writing will reduce cost basis. The decision to use option-selling to mitigate share depreciation losses depends on several factors and is not necessarily a better approach than simply selling the underlying.

New Blue Hour webinar uploaded to your premium member site

Blue Hour # 6 has been added to the member site. It is titled “Bear Market Strategies” One of the advantages of option-selling is that it can be crafted to succeed in most market environments. This webinar addresses how to set up and manage our covered call writing and put-selling portfolios in bear and volatile market conditions.

Market tone

Global stocks moved up slightly this week, with major US indices once again setting new highs. The price of West Texas Intermediate crude oil rose over $3 a barrel to $49.65. Volatility, as measured by the Chicago Board Options Exchange Volatility Index (VIX), rose to 10.29 from 9.9 a week ago. This week’s economic and international news of importance:

• US economic growth increased in the 2nd quarter, rising 2.6%, up from the first quarter’s 1.2% pace
• Modest growth averaging around 2% looks to be likely again in 2017. This should keep the US Federal Reserve on a gradual rate-hiking path
• The Fed indicated it is ready to begin trimming its balance sheet
• The Fed held rates steady while acknowledging that inflation is running below its 2% target.
• The International Monetary Fund maintained its forecast for 3.5% growth in gross domestic product this year. The fund lowered its outlook for US growth to 2.1% from a previous reading of 2.3% while raising its outlook for the eurozone and Japan. It downgraded its outlook for UK growth
• Now that the health care bill has been defeated, Senate leaders hope to move on to tax reform and to passing a spending bill in order to avoid a government shutdown at the end of September
• President Trump reiterated his desire to slash the US corporate tax rate to 15% from 35% while lowering the tax burden on the middle class
• Congressional leaders and administration officials agreed to table the border-adjustment tax that would have taxed US imports
• Credit rating agency Moody’s has upgraded its outlook on the Chinese banking system to stable from negative
• According to Thomson Reuters, with 48% of the members of the S&P 500 Index reporting, second-quarter earnings are expected to rise 10.7% versus Q2 2016
• Revenues are expected to climb 4.9Forthe week, the S&P 500 rose by 0.54% for a year-to-date return of 10.44%

For the week, the S&P 500 moved down by 0.02% for a year-to-date return of 10.42%

THE WEEK AHEAD

Mon, July 31st

• Japan Industrial production
• China Non-manufacturing purchasing managers’ index
• Eurozone Unemployment report, consumer price index

Tue, August 1st

• Global Manufacturing purchasing managers’ indices
• Eurozone Q2 preliminary gross domestic product
• Personal income, spending, personal consumption expenditures

Thu, August 3rd

• Global Non-manufacturing purchasing managers indices
• Eurozone Retail sales
• United Kingdom Bank of England rate-setting meeting

Fri, August 4th

• Employment report

Summary

IBD: Market in confirmed uptrend

GMI : 5/6- Buy signal since market close of July 13, 2017

BCI: I am currently favoring out-of-the-money strikes 3-to-2.

WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US

The 6-month charts point to a mildly bullish outlook. In the past six months, the S&P 500 was up 8% while the VIX (10.29) moved down by 13%.

Original Post

Written By: Dr. Alan Ellman