Double Your Income with This Exit Strategy

10/02/2012 7:00 am EST

Focus: OPTIONS

Alan Ellman

President, The Blue Collar Investor Corp.

In options, just as in baseball, hitting a double could pay off big. Alan Ellman shares his profitable exit strategy on covered calls.

Maximizing covered call writing returns requires the use of a series of exit strategies. One of the most common mistakes covered call writers are guilty of is not managing trades during the contract cycle. I was guilty as charged when I first started using this great strategy and learned my lessons the hard way. I share my experiences with our BCI community in hopes that our members will develop the skills to maximize returns without having to pay for those lessons.

One of my favorite exit strategies is “hitting a double” (my term, not found in Wall Street insider books). By being prepared to use this strategy we can actually generate a second income stream in the same month with the same cash. When we “hit a double,” we buy back the option (buy-to-close) assuming it meets our 20%-10% guidelines, and simply watch the stock price without taking additional immediate action. Here, the goal is to wait for the underlying equity to appreciate in value in a relatively short period of time after the initial buy-back of the option, thereby driving up the option value. If this occurs, we can sell the exact same option (same strike and expiration date) and generate a second income stream from the same option, or, in other words, “hit a double“. Over the years, I have actually also hit a few “triples,” wherein the same option was sold three times prior to its expiration!

As a rule of thumb, we attempt to “hit a double” when the market tone and stock technicals are mixed to positive earlier in the contract period (especially during the first week or early in the second).

NEXT PAGE: Real-life example of “hitting a double” |pagebreak|

Real-Life Example of “Hitting a Double:”
The chart below depicts an actual example of when I “hit a double” with respect to a prior covered call position in Blue Coat Systems, Inc (BCSI), which ultimately generated an additional $868 into my account. Bear in mind that the additional $868 does NOT include the original $992 I “earned” when I sold the option for the first time. First, let’s look at the chart for BCSI as it existed at the time this exit strategy was implemented:

chart
“Hitting a Double” with BCSI
Click to Enlarge

Note how BCSI took a big plunge (blue arrow) and then recovered quickly over the next two weeks (red arrow). Here are the four prongs of this one-month investment:

  • 10/26/09 – Purchased 1000 shares of BCSI @ $25.35

  • 10/26/09 – Immediately sold 10 contracts of the slightly in-the-money November $25 call option for $1.35, generating a profit of $992 (I deducted the intrinsic value of $0.35, as well as commission, in calculating the latter $992 figure). Should I be happy and complacent and head for the mall? Not Blue Collar Investors!

  • 10/30/09 – Took advantage of a market dip and bought back the 10 contracts for $0.25 per contract ($250 in total) in accordance with our 20% guideline, thereby creating a debit of $262, inclusive of commissions.

  • 11/5/09 – Took advantage of a price upswing (red arrow) and re-sold the EXACT SAME 10 OPTIONS for $1.15. This generated an additional $1130 into my account, inclusive of commissions. Thus, my net gain in connection with the utilizing the “hitting a double” exit strategy in this example is $868 ($1130 – $262). It took me less than 5 minutes to buy back the option, and less than 5 minutes to re-sell the option a few days later. Now, if that doesn’t put a smile on your face, let’s add in the initial option profit of $992, for a total profit of $1860 ($992 + $868).

  • Our original investment was $25,000 using the intrinsic value of the first option premium to “buy down” the cost of the stock from $25.35 to $25 (use the Ellman Calculator if this part troubles you). As such, our one-month profit or ROO is: $1860/$25,000 = 7.4%, one-month return. So now it’s time to head to the mall, right? Nope, still two more weeks until expiration Friday!

Conclusion:
As demonstrated in the above-referenced example, the “hitting a double” exit strategy is best utilized when the underlying equity, and thus, the option premium, will appreciate in value in a relatively short period of time after having declined in value. If, however, the price of the underlying equity does not appreciate in this manner, we can then look to roll down, or alternatively, to possibly implement our third exit strategy, which involves selling the stock and “converting dead money to cash profits.”

By Alan Ellman, President, The Blue Collar Investor

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