When most of the time value is realized, it’s makes sense to exit mid-contract, writes Alan Ellman.
Exit strategies for covered call writing and short cash-secured puts is one of the three-required skills that must be mastered to successfully trade options. The mid-contract unwind exit strategy is used for covered calls when share price moves substantially above the strike price, leaving the strike deep in-the-money (ITM). One of the characteristics of a deep ITM strike is that the time-value cost-to-close approaches zero as it trades near parity (all intrinsic-value). This strategy is normally implemented mid-contract before Theta (time-value erosion) has removed opportunities for additional time-value profit.
There are times, however, when increased market volatility will allow mid-contract unwind opportunities later in the contract. As market volatility increases, so will the time-value of our option premiums. Such was the case on March 18, 2020.
Comparison chart of the S&P 500 and the CBOE Volatility Index (VIX) in March 2020
This three-month chart shows the VIX up 461% and the S&P 500 down 29%. This huge spike in market volatility created mid-contract unwind opportunities with only 2.5 days remaining to expiration of the March 2020 contracts.
MCU with SH, XLP and XLV
In March, the Coronavirus crisis was causing the spike in volatility and decline in the overall market. I held a position with the ProShares Short S&P 500 (SH). Because the market was falling precipitously, SH moved up substantially leaving the call in place deep ITM. The mid-contract unwind exit strategy was implemented and two SelectSector SPDRs: Consumer Staples Select Sector SPDR Fund (XLP) and Health Care Select Sector SPDR Fund (XLV) were purchased and calls were sold.
Brokerage screenshot of March 18 mid-contract unwind trades
MCU Trades on March 18, 2020
- SH $27.00 call was bought back at a time-value cost-to-close of 11¢ per share
- The cash was used to purchase shares of XLP and XLV
- Covered calls were sold on the newly-acquired shares generating an additional $1,041 in option premium
Discussion
Exit strategy opportunities can occur at unusual times. We must be prepared to identify and take advantage of these moments. Mid-contract unwind exit strategies are generally reserved for early-to-mid-contract because it depends on adequate time-value to execute. However, in times of increased market volatility, mid-contract unwind may be implanted much later in a contract.
Use the multiple tab of the Ellman Calculator to calculate initial option returns (ROO), upside potential (for out-of-the-money strikes) and downside protection (for in-the-money strikes). The breakeven price point is also calculated. For more information on the PCP strategy and put-selling trade management click here and here. I'll be presenting a free, one-hour webinar for the Options Industry Council on Wednesday May 8 at 3:30 p.m. CST, entitled, Covered Call Writing: Basics and Practical Application. The event is open to all. Just follow the link above to register.
Even if you feel you may not be able to attend the live presentation, sign up and receive a recording to review at your leisure.
