Knowing When to Get Out of Risky Covered Calls Is Key

06/19/2020 6:00 am EST

Focus: OPTIONS

Alan Ellman

President, The Blue Collar Investor Corp.

Risky stocks can result in challenging decisions and knowing when to unwind, notes Alan Ellman.

Writing covered calls with high-volatility stocks will result in higher premiums. That’s the good news. These securities may also decline substantially below the strike price and cause option premium to pale in comparison to the share depreciation. That’s the bad news. What if these shares move up exponentially, leaving the strike deep in-the-money and we are faced with the decision whether to close the short call? This is a real possibility especially with a high-volatility underlying stock.

In this article, a real-life example with Axsome Therapeutics, Inc. (AXSM) will be used to highlight such a scenario. 

The initial trade

  • Dec. 2, 2019: Buy AXSM at $33.39; Sell-to-open the Jan. 17, /2020 in-the-money (ITM) $32.50 call for $12.90
  • Dec. 4, 2019: Share price gaps-up to $45.40; Cost-to-close the $32.50 call is $20.90

Initial calculations for the initial trade

calculatorAXSM Calculations with the Ellman Calculator

The initial seven-week initial time-value return ROO) is a huge 37% (275% annualized) with 2.7% downside protection of that profit. This immediately flags this stock as highly volatile and risky. Most conservative option-sellers would avoid a security like this one due to the downside risk. This is the most important takeaway of this real-life example but we will go further because this story does, in fact, have a happy outcome.

Why did the price gap-up?

One of AXSM’s trial narcolepsy drugs had a favorable Phase 2 result. Share price skyrocketed up by $12, leaving the $32.50 strike deep-in-the-money. At this point the maximum return of 37% was looking secured.

Should we close the short call?

The cost-to-close was $20.90 with intrinsic-value of $12.90 ($45.40 – $32.50) and time-value of $8.00. This time-value cost-to-close represents about 67% of the initial time-value profit. The exit strategy where we close an entire covered call position early-to-mid-contract is known as the mid-contract unwind exit strategy in our BCI methodology. We move forward when we can generate more than an $8.00 cost-to-close (about 26%). Unless we chance another highly volatile stock, this is unrealistic and so this exit strategy initiation is not indicated at this time.

Discussion

Using highly volatile underlying securities is risky and not appropriate for most conservative investors using option-selling strategies. When the implied volatility results in share appreciation, closing the short call depends on the time-value cost-to-close. We use the “Unwind Now” tab of the Elite version of the Ellman Calculator (free to premium members in the resources/downloads” section of the member site) to assist with these decisions. Most of these situations can be avoided by selecting more appropriate stocks based on our personal risk-tolerance. We do so by setting an initial time-value return goal range that protects us against risky trades (2% to 4% per month, for me).

To learn more about the mid-contract unwind exit strategy, see the exit strategy chapters in the following books/DVDs: Complete Encyclopedia for Covered Call Writing- Classic Edition, Complete Encyclopedia for Covered call Writing- Volume 2 and Covered Call Writing Online Streaming DVD Program with Downloadable Workbook
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

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