Mastering option trading basics includes incorporating exit strategies into our portfolio trades, writes Alan Ellman of TheBlueCollarInvestor.com, and these opportunities present themselves both when a stock price declines and accelerates.
Recently, a premium member presented me with a hypothetical trade involving FSLR that I felt would be of interest to the entire BCI community. Let me preface my remarks by saying that FSLR is NOT currently on our premium watch list but has been in the past. Here are the particulars and then we will discuss.
- March 18: Buy FSLR @ $27.25 and sell the April $28 call for a 3.5% initial, one-month profit
- April 9: Price of FSLR gaps up to $39 and the $28 call option to $11.10
- The additional share appreciation brings the trade profit to > 6% and is maxed out no matter how high the price goes
- There is an upcoming earnings report prior to the May expiration
Let's take a look at the price chart of the stock showing the gap up:
FSLR price gaps up
Next, let's look at the price chart of the April $28 call option demonstrating the corresponding gap up:
FSLR April $28 call option gap up
The question posed to me was which of the following actions should we consider?
- Buy back the $28 call and roll up to a higher strike to benefit from additional share appreciation
- Since the earnings report negates the choice of rolling out, just allow assignment after expiration Friday
- Another choice?
Let's review these choices:
Rolling up in the
I generally don't take this approach because a stock that has gapped up may decline in price due to profit-taking (which it did as of this writing). In addition, we will be incurring an option net debit and thereby depending on further share appreciation to make this approach profitable. Let's reject rolling up in the same month.
Allow Assignment After Expiration Friday
An astute observation by this member to avoid the next month earnings report. This is a viable choice if there is none better. A > 6%, 1-month return with protection all the way down to $28 is not a bad deal!
Another Choice (Notice How I'm Avoiding the Word
You know how I love to squeeze every ounce of profit from our trades and we may be able to do so here. Because of our option obligation, our shares are worth $28, not $39. If we close our short options position and buy back the $28 call for $11.10, our shares are now worth market value or $39. Let's do the math:
$11.10 debit (buying back the option) + $11 credit (share appreciation from $28 to $39) = net debit of $0.10 = $10 per contract.
Since we no longer have an option obligation, we can sell our shares for $3,900 per contract and put this cash right to work. If we can institute a NEW covered call position in the last nine trading days of the April cycle, which generates more than $10 or four tenths of 1%, then we have successfully instituted an exit strategy and created a second income stream in the SAME month with the SAME cash. I call this the mid-contract unwind exit strategy.
By Alan Ellman of TheBlueCollarInvestor.com
Tickers Mentioned: FSLR