Closing Our Entire Covered Call Position When Share Price Rises: The Mid-Contract Unwind Exit Strategy

11/04/2014 8:00 am EST

Focus: OPTIONS

Alan Ellman

President, The Blue Collar Investor Corp.

Using a real-life example for support, Alan Ellman of TheBlueCollarInvestor.com, explains how, as an options trader, there are times to take action when the trade turns out to be much better than anticipated…a short-term acceleration in price.

Exit strategies or position management is one of the three major components of this strategy we must master to become elite covered call writers. The other two are stock (or ETF) and option selection. I mostly focus on scenarios that can result in losses and how to mitigate those losses or turn them into gains. However, there are times we need to take action when the trade turns out to be much better than we anticipated…a short-term acceleration in price. I refer to this strategy as the mid-contract unwind exit strategy. With the market rebounding significantly recently, opportunities have been created. Several of our members have recognized these favorable circumstances and inquired as to the best time to close a position when share price rises substantially in a short time frame. These inquiries motivated this article.

If we purchased a stock @ $48 and sold the $50 call for $1.50, we generated a 3.1% initial option return. If share price moves up to $60 in the first half of the contract, we have another $2 in share profit ($48 to $50, the strike price). That is a 7.3%, 1-month return and appears to be maxed out because there is no benefit to us if share price rises higher due to our option obligation to sell @ $50. The only way we would not achieve maximum returns on this trade is if share price drops > 10 points to under $50.The BCI guideline as it relates to the mid-contract unwind exit strategy is to always close the entire covered call position (short option and long stock) when the time value component of the option premium approaches zero in the first half of a contract. When an option is trading @ intrinsic value only, it is said to be trading @ parity.

Let’s look at a real-life example taken from the recent Premium Watch List dated 10-24-14. The stock is JAZZ Pharmaceuticals (JAZZ). Here’s the trade:

  • 10/20: Buy JAZZ @ $152.26
  • 10/20: Sell $155 OTM call @ $3.35 for a 2.2%, initial 1-month return (share profit = $2.74/share)
  • 10/20: Max profit achieved = 4%
  • 10/30: JAZZ is trading @ $168.36
  • 10/30: $155 call’s last trade was $13.35 with intrinsic value of $13.43

Here is a linear price chart of the $155 call option showing initial and current values:

chart
Click to Enlarge

Next, we will review the options chain for JAZZ on 10-30-14:

chart
Click to Enlarge

If we can execute the trade to close our short position at, or near, $13.43, it will meet our requirement to close when time value approaches zero. Let’s assume we can close for $13.50, an amount above the last trade. Of that $13.50, $13.43 is intrinsic value, the amount the $155 strike is in-the-money. In this case, we have an option debit of $13.50 to close but a stock price credit of $13.43 because we are no longer obligated to sell @ $155. Our net cost to close (excluding commissions) is $0.07 or $7/contract. When the shares are sold, we have maxed our initial trade in the month (November contract in this case), less $7,  and have now freed up all the cash from the stock sale to initiate another covered call trade in the same month with the same cash. We have two incomes streams from this same cash amount. To make this a successful exit strategy, all we need to do is generate an amount greater than $7/contract.

Summary

When share value rises significantly in the first half of an option contract after entering a covered call trade, buy back the option when its time value component approaches zero and the amount that can be generated in a subsequent trade exceeds the debit incurred in closing the initial trade.

By Alan Ellman of TheBlueCollarInvestor.com

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