Systematic Covered Writing

... more than just covered calls!

The Recover After Expiration Strategy

       

MATH EXERCISE:

There are two basic approaches to recovering a position when an option expires. One approach is to generate as much cash as possible with the highest strike price possible. This has been the philosophy followed by Systematic Covered Writing over the past four years. Generally, a replacement option six to twelve months was selected, as the focus was on generating the greatest amount of cash NOW.  Please note that there is nothing wrong with this idea, and in some cases, the process will remain exactly as it has been since 2001.

Having said that . . . SysCW is not a static process. It is continually being evaluated with the desire of achieving improvements in the overall process with the aim of higher average returns. The simplest way to explain the new thought process is by considering a position where the stock has lost value, and is now ready to be recovered.

THE STOCK: RMBS 

THE SAGA:   Stock was purchased and the Initial Call Option expired in January 2007. Here is the data a covered writer would be looking at as he or she considers recovering the position:

FYI . . . We have two individual Initial Positions that were established in 2006.  Both options expired on January 20, 2007.  The writer then deleted the extra rows which separated the two positions, and calculated the combined position information.

Previously, the philosophy would have been to immediately look at either six month calls or twelve January LEAPS in order to generate as much cash as possible with the new call option.  With a cost basis of $27.87, the $25 strike price would be optimal, but with the stock trading at $17.85, the writer would consider $22.50 or so.  This is possible because the writer understands that if the strike is two low, and the stock moves above it, there are Systematic Covered Writing strategies that can be used to prevent the stock from being sold at an undesirable price..

Note that quotes are a snapshot in time, but as of January 2007 expiration weekend the following data was available:

As you can see, even though the stock is at $17.85, the writer could generate about $480 with two of the Aug $25 calls, or by selling two of the '08 Jan $30 LEAPS, the writer would generate about $510. In the latter case the strike price would be above the cost basis. Again . . . there is nothing wrong with this thought process!  Add the $510 to the cash that has already been generated, and you'd be looking at about $2123 is cash from a $5573 investment  for the first two years (2006 - 2008).  The 38% cash generated would be above expectations, and IF the stock is called . . . even more cash would be generated. 

BUT . . . . for 2007 is the new idea that possibly one could do better!  What if, instead of generating as much cash as possible NOW, the focus is switched to generating as much as possible between NOW and THEN? The only reason this thought process is even remotely possible is because the writer already has the downside protection 'in the bank'.  In other words, how about generating the downside protection with the Initial Position, and then trying to generate more cash over time by using shorter term options?

Hence the need for the new Math Exercise for the Recover after Expiration strategy. An example of this Excel tool is provided below for the RMBS position listed above.

*Clarification: The 200 shares of stock were not purchased on the same date. March 15th is an approximate midpoint based on an actual mid-date of April 20th, coupled with the fact that the first purchase was larger than the second.

THE DATA: Please note this Math Exercise, and the Excel template subscribers received, is based on the auto update features of MSN Money Stock Quotes.  This is a free add on application, which many of you already use. As will all of the templates provided, the yellow cells are for data entry, the green cells are calculated based at that information and the quotes from MSN.

• Date Recovered:  The cell is formatted.  All you would do is enter 1/22 for January 22, 2007.

• New Option: This cell is based on the symbol entered in the yellow Call Symbol cell. DO NOT TYPE IN THIS AREA.

• Cost Basis: You would enter the cost basis per share based on the data in the Position Tracker for this position. The same is true for Cost Basis Number of Shares, Initial Trade Entry Date, and the total Previous Cash Generated.

• Call Symbol: For the option, note that you need a dot (period) as a leader for the option symbol. Once you enter the symbol and press <enter>, the description will change under the date, the current bid price will update, and the strike price will adjust based on the symbol. Please note the Bid value will change if you update the price quotes at a later date.  It would be advantageous to use the master to create new pages for a position that needs to be recovered, then once the position is covered, you could type the fill price in the green sell to 'fix' its value. This way the math would not change over time.

• New Expiration Date: Enter the expiration Friday date for your new option position.

• New Duration in Months*: Based on the date of the trade and the expiration date that is entered manually, the number of months is calculated automatically.

The rest of the information is this section is the same as it always has been.  Looking at the new Recover Analysis section . . .

• Enter New Duration in Months: Just type the digit that is calculated above for the number of months. Everything else is automated!

• Potential Cash Per Year: This figure makes a huge assumption, but the amount is 'real'.  It basically tells you IF you could repeat the same transaction over the course of one year, this is how much new cash would be generated.  Note that this amount has nothing to do the purchase price of the stock, or the current price of the stock.  It is based on selling an option (does not have to be the same strike price) for a specified duration (in this case 1 month), over and over until twelve months have transpired.  Note that this amount also has nothing to do with the cash that has already been generated!

• Generation per Year: Here we are dividing the Potential Cash Per Year by the Net Stock Investment .  Again, this is in addition to the cash that has already been generated.

• Adjusted Total Cash in Hand: Here we are making no assumptions other than the new call was filled at the amount listed next to Current Option Bid. This is the cash to date, plus today's premium.

• Percentage of Investment: As always, we divide the total cash generated by the total investment. Please note this does not include any of the Potential Cash per Year other than the amount generated today.

See the difference?  Instead of generating $510 between now and next January, there is a possibility of generating significantly more cash over the same time frame by using shorter term call options. Please remember, what makes this possible is the cash that has already been generated, along with the knowledge of the SysCW strategies that can be used if the strike price is too low.

Beginning Monday, January 22, 2007, subscribers will see many new Recover after Expiration positions established using this updated philosophy. Because it is 'new', there are no historical examples. 

FINAL THOUGHT: Let's be real.  Sometimes we all select stocks that lose 'value'.  This will happen. The positions that are assigned worked out as planned and the writer is back to cash with a predetermined double digit profit.  That's great . . . right? The problem (let's call it a common fear) is what to do with the position where the option expires. Well . . . . if you could generate 8% to 15% with the positions that lost value . . . wouldn't that be okay? 

If the answer to that question is yes (which means you are not living in a dream world), then don't worry about the possibility that some positions may lose value.  Okay?

If you have questions, comments or opinions about the mythology, I'd love to discuss it with you.  We both learn through the exchange of ideas.

The Covered Writer      rlcoveru@cox.net

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PLEASE NOTE THAT THIS EXAMPLE IS NOT TO BE CONSIDERED AS A RECOMMENDATION TO INVEST IN RMBS STOCK OR ANY OTHER EQUITY.  THE INFORMATION IS PROVIDED FOR EDUCATIONAL PURPOSES ONLY.  THERE IS NO GUARANTEE THAT SIMILAR TRANSACTIONS CAN BE EXECUTED IN THE FUTURE. INVESTING IN THE STOCK MARKET INVOLVES RISKS, DO SO ONLY WITH A KNOWLEDGE AND UNDERSTANDING OF THE RISKS INVOLVED!

The information provided above is for informational purposes only, and no mention of a particular security constitutes a recommendation to buy, sell, or hold that or any other security, or that any particular security, portfolio of securities, transaction, investment strategy is suitable for any specific person. You further understand that the Covered Writer will not advise you personally concerning the nature, potential, value or suitability of any particular security, portfolio of securities, transaction, investment strategy or other matter. To the extent any of the information available on this website may be deemed to be investment advice, such information is impersonal and not tailored to the investment needs of any specific person. Always remember that past results are not necessarily indicative of future performance.

These are the terms of use.  Why are they here?  Because the examples provided are real.  The transactions actually took place.  The dates are real, the positions are real.  Some transactions will have been executed on the day you receive the email.  What you are agreeing to, is the fact that in no way is it being suggested that you can, or should, enter a similar position.  Why?  Because that would be providing investment advice and the Covered Writer is not authorized to do that.  There is also no guarantee that similar transactions could be executed at any time in the future. Only licensed brokers are allowed to provide investment advice.  Therefore, you are agreeing that the preceding example was provided for 'educational purposes' for the sole purpose of illustrating the Systematic Covered Writing strategies.

Thank you!

SYSTEMATIC COVERED WRITING
Copyright © 2005. All rights reserved.
Revised: 03/03/11