Seeking Alpha
Profile| Send Message|
( followers)  

Mid-Contract Unwind:

The major concern for covered call writers is the stock price dropping in value. The option premium collected is money in the bank. Most of our exit strategies are designed to mitigate these losses and turn losses into gains. However, as Blue Collar Investors, we should also be prepared to act if the opposite scenario occurs.

From time to time, you will buy a stock, sell the call option and your equity will subsequently dart straight for the moon. That will leave your strike price deep in-the-money. One way of looking at this situation is that you made a significant profit, and now that cash is protected by the difference between the share value and strike price of the option, or the intrinsic value of the option premium (the amount it is in the money). If satisfied with this situation, you will just allow assignment and enter a new position the next contract cycle. There may be, however, an opportunity to generate even more cash in such a scenario, especially when there is still time left until expiration Friday.

When a strike moves deep in-the-money, the time value of that option premium declines and approaches zero. This means that the option premium consists predominantly of intrinsic value. The amount of cash it takes to buy back the option is greatly offset by the share appreciation we would realize by eliminating the option obligation (closing our short option position by buying the option back) and selling the stock. Always consider a mid-contract unwind exit strategy when the time value of the option premium approaches zero and there is enough time remaining in the current contract cycle to generate additional profit with another position.

Real-life example of a mid-contract unwind exit strategy:

There is nothing like a real-life example to clarify the utilization of the mid-contract unwind exit strategy. The charts and graphs below depict the primary stages that occurred when I utilized this strategy in a covered call position for the underlying security, Perrigo Company (NYSE:PRGO). Initially, 300 shares of PRGO were purchased @ $51.10 on March 22, the start of the April contract cycle. At this time, three $50 call option contracts were sold for $2.10, yielding a profit of $100 per contract, given that this premium consists of $1.00 of time value ($2.10-$1.10). A week into the contract cycle, PRGO had appreciated in value to $56.79, and the premium for the corresponding $50 call option had likewise appreciated to $6.90, as illustrated in the two figures below:

PRGO heads to the moon!

PRGO $50 call also heads to the moon.

The drastic increase in PRGO share price and its corresponding option premium in such a short period of time prompts us to explore the potential to generate more profits by unwinding the initial position mid-contract and then selling the stock. In order to examine the viability of this cash-generating opportunity, we must first explore the current options chain for PRGO, below:

(click image to enlarge)

PRGO unwind options chain

In the yellow-highlighted area enclosed by the red circle, we see that the cost to close our short position for the $50 in-the-money call option is $6.90 (we may pay less by playing the bid-ask spread), and that this premium consists of $6.79 of intrinsic value, leaving a time value of $0.11, or $11 per contract. Discounting our miniscule commissions, if we can use the cash from the sale of the stock and generate a higher return than $11 per contract, we have made additional profit. Using the "Unwind Now" tab of the Elite version of the Ellman Calculator, we can see how the original profit of $100 per contract ($210 - $110) has now dipped by $11 to $89. To do this, first we enter the options chain information for PRGO into the blue cells of the "Unwind Now Tab" spreadsheet of the Elite Calculator:

(click image to enlarge)

"Unwind now" tab of Elite Calculator

Next, we view the results generated from the entry of the foregoing information in the "Unwind Tab" of the Elite Calculator, which is depicted below:

(click image to enlarge)

Elite Calculator results

This shows that the original $100 profit was reduced by the $11 to $89. Now if we can use the cash from the stock sale to generate more than $11 (not that challenging to accomplish), we can establish a second income stream in the same contract month with the same cash.

Perhaps, some may feel that we can generate the extra cash by rolling up, however, the following two reasons may render the decision to utilize this strategy an unwise one:

  • The price of the stock may not be in a favorable position to generate a decent return.
  • Given the drastic share appreciation over a short period of time, the possibility exists that profit-takers (sellers) could cause the price to experience a drastic decline in value.

Instead of rolling up, let's look for a new financial soldier to send out into the financial battlefield (this has all been decided prior to unwinding the original position). To do this, we look to our watch list, which contains 40-60 fundamentally sound equities, and (in this example), Bucyrus International, Inc. (NASDAQ:BUCY) surfaces as a viable candidate. We then put BUCY through our technical screens, which (in this example) it passed, as depicted below:

(click image to enlarge)

Technical analysis of replacement security

Next, we look to the options chain for BUCY (see figure below) to obtain the relevant figures necessary to perform our ROO calculations via the Ellman Calculator:

BUCY options chain

With BUCY currently priced at $67.48, we can sell the $65, in-the-money strike for $3.90, which yields a 2.2% ROO, with a huge cushion of 3.7% in downside protection of that time value ($248/6748). This 2.2% figure translates to a $115 per contract "bonus" for instituting a mid-contract position unwind exit strategy.

Conclusion:

When a stock appreciates in value over a short period of time, and there are still two weeks or more remaining in the cycle, unwinding your position may offer an opportunity to generate additional cash into your account. The keys are that the time value of the option premium must be close to zero, and the new position must generate more cash than the amount of time value paid to close the original position.

Disclosure:

I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: Covered Call Writing: Generating A Second Income Stream In The Same Month