Updated: Aug 9, 2019
The purpose of my articles is to always elucidate typical scenarios that may come up and as conservative but rather active investors looking for control we have to be able to understand what we're doing and how the mathematics behind a particular trade are structured. For instance, when we sell a covered call and the share price goes up dramatically, the option we sold gets deep in-the-money indicating we brought our profits to the highest possible level.
With plenty of time left before expiration, we can decide to buy back the option and sell the stock, or to express another way, close both legs of the trade. Nonetheless, most retail investors/the common option seller don't get it when we decide to pay more for the option than we got initially, thinking it leaves them in a very unpleasant and losing feeling. Why don't we take a look at a real-life scenario? Just to be fair, exit strategy execution one element of successful option selling that is commonly misinterpreted by the average investor. So always keep in mind that we'd better not fail to focus on our main principal: understanding what we're talking about and how we control our trades using a wide variety of exit strategies. For purposes of showing you when it pays to close both legs of the trade, I've already written an article which you can read HERE. In this article, I just want to make you aware of allowing assignment, which is another - more often than not - overseen choice we have as option sellers.
Back in 2017, on January 25, Thor Industries was trading at $101.54 and covered calls with a strike price of $100 expiring on February 18, 2017 were sold for $3.43. As you can notice from the chart right below, there was no upcoming earnings release and the technical indicators underpinned bullish momentum.
Now, we sold an at-the-money call (more or less) or slightly in-the-money call. As you know that implies the following three consequences:
No upside potential
Downside risk protection
Lower breakeven level = more conservative = substantial edge compared to traditional investing
First of all, let's see what we can expect from this trade with THOR:
Again, just like with most of the other trades I discuss in this kinds of coaching articles, we target an annualized return of approximately 30% which gives us some cushion if things turn out worse than we forecast. You'll notice right in the middle of the screenshot above that when we purchase the stock at $101.54 and agree to sell those very same shares at $100, we are going to have a 'loss' on the stock side of $154 for the 100 shares. Now, we get compensated for carrying that loss instantaneously when selling the option (we capture a higher premium). And the best part about this zero-sum play is that we bought down our actual cost basis. Why is that important to the option writers? He now has extended the range wherein the covered call trade will remain profitable (from $101.54 to $100 which is a $1.54 difference and quite essential to successful option selling) . The downside is that you are completely capped on the upside if shares rise exponentially, which you would partially have when selling out-of-the-money calls. So, to summarize the trade consisting of 100 shares I want you to focus on the following bullet points:
Initial profit = 1.89% (time value/the in-the-money strike) = 189 dollars as long as share value does not depreciate below $100 (profit protection of 1.5%)
Maximum profit is that very same 1.89% since there's no upside potential because we are obligated to sell at the strike price which is lower than current market value
Breakeven point is set at $98.11 equal to the amount of time value (actual profit) subtracted from the in-the-money strike
Now - as you've probably already seen on the chart above - things turned out much better than we had presumed. On February 11, 2017 shares went up to as high as $107.33 leaving the option we sold deep in-the-money but the actual cost-to-close if we planned to close the trade entirely (buying back the option and sell the stock) was still 0.28% excluding commissions. If you'd add this to the equation the actual cost-to-close would be 0.32%. Now, there was just one week left before expiration Friday and because of rather low implied volatility, there were no attractive stocks to replace this trade. But you can read more on the subject of unwinding HERE. So, we have just one choice being left on our option selling table: allowing assignment. If we don't take action and our covered calls (or puts) are in-the-money, our shares will be sold (bought in case of a put) the day after expiration Friday. Why don't we just buy back the option which is known as rolling? One of my rules is to never ever sell options on a stock when there's an upcoming earnings report. This event creates ample volatility (resulting in an exorbitant cost to buy back the option if we don't want to hold the stock through the earnings release) and thus excessive risk/uncertainty that you don't want to get involved in. And as can be deducted from the chart, there was indeed a devastating impact of the earnings release on THOR's share price.