Updated: Aug 6, 2019
After we've entered a short-term option trade, we go in position management mode in order to take advantage of events that didn't foresee. There's a wide variety of exit strategies and in this venue, I'd like to introduce you the concept of bouncing back which applies to covered call writing only.
Real-Life Example With Galapagos
Let me give you a real-life example I did with Galapagos. I'm using 1 options contract just to keep the mathematics quite simple.
On February 14, 2019 I bought 100 shares of Galapagos and sold an in-the-money call with a strike price of 90 euros for 6.35 euros. The expiration date was March 15, 2019.
First, let's take a look at the initial returns, breakeven level and annualized return.
A very nice 29-day return of 6.67% can be achieved as long as the shares remain above the strike price at expiration Friday and no early assignment takes place. At the time of writing the option, the amount invested in Galapagos was €9,035 but our actual cost basis was €9,000 since we've received €35 of intrinsic value. Intrinsic value represents the amount that an option, be it a call or put, is in-the-money. In case of call options, an option has intrinsic value when we are willing to sell our shares at a price lower than current market value (strike price < current market value).
On February 27, 2019 the price dropped to €85 .
When the price of the underlying security we sold an option on drops in value, the calls will have become worth less. When the option value decreases such to approximately 25% of its initial value (in case of Galapagos that's 25% of €6.35), we decide to buyback the option and wait for the stock to bounce back up again. If not, we can roll down the option to generate a second income stream to enhance profits, mitigate losses or turn losses into gains. When buying back our short options, we don't have an obligation anymore. Since we already own the shares, we're just a shareholder at that point in time, giving us a huge portion of flexibility.
Simply stated, I bought my option(s) back for €1.75 (27% of the initial value). Two weeks later, I re-sold the €90 strike for €4 when the share price had recovered to as high as € 92.15. I didn't get it at its peak, but I got it pretty high.
On March 4, 2019 the price popped back up to over €90.35
On March 4, 2019 I sold the same option (same strike price) for €4
These actions are the depicted in the following price charts. You'll notice that re-selling call options is extremely lucrative when the price is quite overheated based on the technical indicators such as the Slow Stochastic Oscillator.
The only few things we have to do is to fill the gray cells. Since stocks tend to fluctuate every single day, we are able to figure out our actual profit, time value remaining and downside risk protection of our profit utilizing the Elite calculator.
As can be noticed from the screenshot provided above, our initial profit was 6.67%. Had we not moved forward with this exit strategy, we simply woudn't have generated an additional 2.50%. So, just by being prepared and instituting this exit strategy, we were able to take our profits to even higher levels (annualized returns in excess of 100% are quite rare I have to admit :-) ). Also, by garnering more premiums, we've lowered our break even from €84 to €81.75.
Had we decided to completely exit our position (closing both legs of the trade; buying back the option first, then selling the stock), we would have incurred a loss of 0.83% since there was still plenty of time value left in the option.