Systematic Covered Writing
... more than just covered calls!
CLOSE the POSITION
One of the fundamental Systematic Covered Writing guidelines is as follows: It's okay to take a profit.
When any Initial Position is established, one of two events will take place. Either the option will be exercised or it won't. There are no other choices naturally occurring choices. Before a covered call position is established, a simple math exercise to determine ahead of time, what the annualized return will be if the option is exercised … sound familiar?
Fortunately, the only ‘two events’ scenario is not quite accurate! We have seen numerous examples where a covered writer intervenes and closes an active call before the option is exercised.
As we know, one of the five changes in value that can happen to a stock which is purchased is referred to in this material as Event 5… namely a significant amount of appreciation occurs prior to the expiration date of the existing option. Sometimes, the increase in value is caused by better than expected earnings, or the announcement of a stock split. It might be a merger, the approval of a new drug or some other 'newsy' event. Whatever the reason, the stock just ‘takes off’. We've all seen it, and believe it or not, it still happens. The question becomes, is there something a covered writer should do when this happens?
There are two choices. One would be to just wait and allow the option to be exercised, which would mean the stock would be assigned. The other possibility is to close the position early, and take the profit. Again, recall one of the other basic guidelines to the SysCW philosophy. Cash generation is the key.
Here is the thought process. A position is established with a call that expires in six months. Two months later the stock has appreciated significantly, and unless there is a reversal in the trend, the stock will be called at some point. A covered writer knows exactly what he or she paid for the stock, and the writer also knows exactly how much they received for the call option.
Here's the point, at any moment in time, a covered writer can figure out how much it would cost to 'buy back' the active call option. Once the call is closed, the underlying stock could be sold at the current market price. If both transactions are executed, the position would be back to cash. By using a simple math exercise, a writer could compute the potential cash gain, the percentage gain for the period, and finally the annualized return. To be clear … this ‘math’ would be completed before the position is closed.
Of course … there is a method to the madness.
RULES
Each SysCW strategy has its own set of specific rules. For the Close it or Wait, the rule is quite simple.
· Does closing the position result in a back to cash gain that meets the writer’s expectations?
This is not hard to figure out and it does note require a broker or an accountant to figure out if closing a position early is a worthwhile venture. As with most of the SysCW activity, all that is needed is a little bit of math. Follow this for a moment. There are four transactions involve if an Initial Position is closed manually. Two of them would have already happened, and two wuld be executed to close the position if the math works!
|
The Stock |
The Option |
|
Proceeds for tock liquidation |
Proceeds from selling call option |
|
Minus investment in stock |
Minus cost to close option |
|
= Sum = Stock Profit |
= Sum = Option Profit or Loss |
Here's what you would do manually.
1. Take the current BID price of the stock times the number of shares and add your commission charges. This would be the potential proceeds from liquidating the stock holding.
2. Use the ASK price for the call option, times the number of shares and add your commission charges. This would determine the net cost of closing the existing call option.
3. Subtract your net cost basis (what you paid for the stock) from the result of step ONE. This will be the profit from the sale of the stock.
4. Subtract the amount it will cost to buy back the option, which is the result of step TWO, from the net amount you received (the premium) when the option was sold. This amount will usually be negative ... that's okay.
5. Add the result from step THREE to the result from step FOUR, if both amounts are positive, which can happen, or subtract the amounts if step FOUR is negative. The result of this activity would be the potential net profit.
NOTE: There is no guarantee the transactions can be executed at any given price, but as long as the trades are executed one right after the other, the math should work out just fine.
If a writer can compute the potential net profit (steps one through five above), then a writer can also compute what he or she really wants to know.
6. Divide the (potential) net profit by the cost basis (net investment amount). This will provide you with the return percentage for the new duration of the position.
7. Determine the number of days the position has been active. This is the duration to date.
8. Divide the result of step SIX by the duration determined in step SEVEN, and then multiply the result by 365. The result will be the potential annualized return.
NOTE: This has been stated a number of times, but always remember when you annualize a return, you are assuming that similar transactions could be successfully executed throughout the course of a year. There is no guarantee that this can be accomplished.
There is an MS Excel spreadsheet that ‘does’ the math. There is also one more step that should be taken prior to actually closing a position early. The math above determines how a position would end if it were closed early. The results should be compared to the ‘math’ of just leaving the position alone, and allow it to continue naturally towards assignment.
Time for some
.
This information is provided for educational purposes only and should not be considered as otherwise. No example or statement presented should be construed as a recommendation to buy or sell a security, be it a stock or call option.
SYSTEMATIC COVERED WRITING
Copyright © 2006. All rights reserved.
Revised:
04/20/11